Asset Classes Explained: The Building Blocks of Your Portfolio

Balance is important to many things in life. And it all starts with a strong foundation. It’s true for investing too.

When it comes to putting together a well-balanced portfolio, it starts with understanding the different types of investments that are available to you.

Let’s look at asset classes and how you can use them to build robust investment portfolios.

What Are Asset Classes, and Do You Need More Than One?

Asset classes are the essential building blocks of your portfolio. Each asset class is a collection of investments with similar characteristics and behaviors.

If you have only one asset class in your portfolio, your success will depend on how well that one type of investment performs. Many people avoid putting all their money in one basket to avoid a significant loss that they cannot recover from.

Combining asset classes, known as diversification, is a fundamental principle of investing that helps you avoid big swings in value. The idea is that when some investments are doing poorly, others are doing well.

Diversification gives you the potential to offset some losses with gains elsewhere and experience a smoother pattern of performance over time.

How Do You Choose Asset Classes to Invest In?

Investors generally regard three asset classes—stocks, bonds and cash—as the core of portfolio construction. Beyond this trio, you'll encounter additional asset classes and sub-asset classes that may further enhance your portfolio diversification.

You must think about the trade-off between risk and reward when deciding which asset classes to invest in. More return/reward potential comes with more risk.

You also want to consider the role each asset class can play in your portfolio.

Stocks Add Potential to Grow Your Portfolio

When you buy stocks, you are investing in the progress of different companies and the economy in general. While stocks have higher growth potential than some other asset classes, they also are subject to market volatility when expectations change. Economic conditions, market sentiment and a company's performance can affect returns.

You can break down stocks into specialized subcategories, including size (known as market capitalization), style and sector. You can also choose to invest in developed countries all over the world and emerging markets, which feature developing economies.

Real Estate Investment Trusts (REITs)

Publicly traded REITs are a sub-asset class of stocks and typically do not move in lockstep with stocks or bonds. With REITs, you invest in a group of companies that own and manage properties that generate income, like offices, apartments and retail centers—you don't own the physical properties. Some REIT strategies may also invest in the loans used to finance various properties.

The return you earn from holding REITs is a combination of dividend income and long-term capital appreciation. REITs must distribute at least 90% of their taxable income as dividends, so when rents rise, those dividends increase. That’s one reason REITs may help you stay ahead of inflation.

On the other hand, REITs are subject to property market fluctuations, interest rate changes and tenant demand. Economic downturns can negatively affect rental income and property values.

Bonds May Provide Income and/or Less Volatility

Bonds, also known as fixed-income investments, are essentially loans investors make to governments, government agencies, corporations or other entities. Higher-quality bonds can serve to reinforce the foundation of your portfolio and may provide a steady stream of interest income. They tend to do well when stocks decline, which may help lower volatility in your portfolio.

A bond's credit rating* reflects its quality. Investors perceive higher credit ratings (AAA being the highest) to have lower credit risk. Credit risk measures the bond issuer's financial strength and ability to make timely interest payments and repay principal at maturity.

Investment-grade bonds have credit ratings of BBB or higher. They have lower default risk but also lower potential for yield compared with non-investment-grade bonds. The trade-off for higher yield potential is lower credit quality.

High-yield bonds have credit ratings of BB or lower. Corporations largely issue these bonds, and performance is closely tied with the corporation’s fundamentals and business results. Therefore, high-yield bonds tend to move more in line with the stock market than investment-grade bonds.

All bond prices are sensitive to changes in interest rates, which can affect your returns. Rising interest rates can lead to lower bond prices while falling interest rates generally lift bond prices. A bond’s total return measures the combined effects of price changes and yield.

Government and corporate bonds are the largest components of the bond market. However, there are other types of bonds. Here’s a sampling:

• Treasuries are issued by the U.S. government with high credit quality ratings because they are backed by the full faith and credit of the government.

• Sovereigns are issued by governments and priced in their native currency. (UK government bonds (gilts) are sovereign debt for U.S. investors.)

• Agencies are issued by government agencies created to fulfill specific needs, such as providing credit to homebuyers. Some agency securities are backed by the full faith and credit of the government, while others are guaranteed only by the issuing agency.

• Corporates are issued by public and private corporations with varied credit quality.

• Inflation-adjusted bonds are issued by the government and corporations with principal and interest adjusted for inflation.

  • Treasury inflation-protected securities are a class of U.S. Treasury securities in which the face value changes along with the inflation rate.

• Municipals are issued by state, city and local governments with income exempt from federal income taxes. In some cases, income from interest payments is exempt from state and/or local income taxes.

• Securitized debt are securities created from pools of similar assets, such as mortgages or credit card receivables. The credit quality can vary greatly depending on the characteristics of the underlying debt. The credit quality of the securitized debt issuer and other economic or financial conditions may also influence value.

  • Mortgage-backed securities are pools of mortgage loans and their payments.

  • Asset-backed securities are pools of income-generating assets, such as car loans, home equity loans, student loans, small business loans and credit card debt.

• Emerging markets debt is issued by countries whose economies are developing or emerging from underdevelopment and corporations located in those countries. Investors consider these bonds risky because there is less certainty that the issuers will make their payments. Other risks include political instability and currency fluctuations.

Cash and Cash Equivalents Offer Access to Your Money and Help Preserve Capital

Cash and cash equivalents—assets such as savings accounts and money market funds—are appealing for their high liquidity. Liquidity describes how easily someone can access their money or buy or sell a security without dramatically changing its price.

With ease of access to your money typically comes low average annual returns compared to other asset classes. That means holding cash and cash equivalents often won’t keep up with inflation over time. Instead, it gives you more stability of principal when market uncertainty hits and as you get closer to withdrawing money from your portfolio.

Alternatives Are Unique Investments With Unique Risks

Alternative investments are asset choices outside traditional stocks and bonds that lack their liquidity. They also can be investment strategies that use a variety of higher-risk tactics, including short selling and hedging.

Examples of alternative assets:

Private Equity Funds

As the name suggests, private equity funds invest in privately held companies. You won’t find these companies in well-known market indices  like the S&P^® 500 Index or the Dow Jones Industrial Average.

Private equity offers the potential for higher returns than public equity over an extended period. But it has high minimum investments and long investment horizons. Typically, you must keep your money invested for a minimum period, such as three to five years, and often from seven to 10 years.

Commodities

Commodities represent important resources such as oil, metals and agricultural products. Investing in commodities allows you to participate in the global supply and demand dynamics of key materials essential to a country’s growth.

Historically, commodities have risen in value along with inflation. Yet geopolitical events, weather conditions, producer issues and economic factors can unexpectedly influence commodity prices, making them volatile.

Art

Stories of someone finding a long-lost work of art in an attic or secondhand shop and earning returns far outpacing stocks and bonds have lured many people to the global art market.

You could own an actual physical piece of art, and now you can find exchanges to buy shares in individual works too. Digital art is another category that has gained interest in recent years.

However, it’s important to recognize that the art market is largely unregulated and highly speculative. And the value changes based on the interests of society at any point in time.

Is Cryptocurrency an Asset Class?

Cryptocurrencies, such as bitcoin and ethereum, are digital assets  that have gained significant attention in recent years. Some people view cryptocurrencies as a new asset class, but they currently lack the regulatory protections and oversight that you have with stocks and bonds.

It's essential to research and consider the risks associated with cryptocurrencies before including them in your portfolio.

Which Asset Class Has the Best Historical Returns?

Every investor wants to be in the best-performing asset class every year—but no one has a crystal ball. Asset class returns and top performers vary every year, and there’s no predictable pattern to bank on.

Building Your Future Block by Block

Managing your investments starts with understanding asset classes. Learning about their past performance, their responses to different market conditions and their risks can help you make better decisions about what you invest in.

The right mix for you should take into account your age, risk tolerance and goals for the future.

If diversifying a portfolio on your own seems daunting, asset allocation funds do it for you. You can choose a professionally managed portfolio based on how much risk you want to take or how much time you have to save for your goal.

Remember, seeking advice from financial professionals is another valuable resource as you embark on your investment journey.