Asset Allocation vs. Asset Classes: What’s the Difference?

You can’t have asset allocation without asset classes. Putting together a portfolio starts with understanding the different types of assets and investments that are available to you. Your asset allocation then describes what you actually own.

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

What Is an Asset Class, and Do You Need More Than One?

Each asset class is a collection of investments with similar characteristics and market performance.

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 help prevent a significant loss that they cannot recover from.

How Do You Choose Asset Classes to Invest In?

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

You should 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 subasset 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 may serve to reinforce the foundation of your portfolio because bond returns historically have tended to be positive when stock returns have been negative. They may also provide a steady stream of interest income.

Investors look at credit quality to assess a bond issuer's financial strength and ability to make timely interest payments as well as repay principal at maturity. The trade-off for higher yield potential is lower credit quality, which means a higher risk that the issuer could default on payments.

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.

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.

Compared to other asset classes, cash and cash equivalent investments earn lower average annual returns that usually won’t keep up with inflation over time. However, you may experience 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, in the pursuit of higher returns than general stock or bond market averages.

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.

Similar to art, a cryptocurrency’s value can change rapidly based on the actions of a small group of buyers and sellers. Before including cryptocurrencies in your portfolio, it's essential to research and consider the risks associated with them.

How Is Asset Allocation Different From Diversification?

Asset allocation refers to how a portfolio is divided across asset classes. It is commonly shown as the percentage each asset class represents in a portfolio—it is not the same as diversification. For example, someone could have an undiversified asset allocation  of 100% stocks or 100% bonds.

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

What Is a 60/40 Portfolio, and How Can It Help You?

An asset allocation of 60% stocks and 40% bonds is widely considered a standard diversified allocation. So-called “balanced” portfolios usually have this allocation because it’s historically shown to offer an attractive balance of stock and bond exposure.

Over time, a 60/40 portfolio has generated solid returns with less risk than an equity-only approach. However, stock and bond risk and return relationships change over time, and 60/40 portfolios aren’t immune to negative results. But on average, these asset classes have complemented each other over long periods.

What Is an Asset Allocation Portfolio?

Choosing your own investments can be difficult, especially when you’re just starting to invest. Asset allocation portfolios do it for you. (Asset allocation funds that invest in mutual funds and exchange-traded funds instead of individual stocks and bonds are sometimes called funds-of-funds.)

Asset allocation funds are popular because they offer advantages that may not be available through individual mutual funds. Consider these benefits:

Multi-Asset Specialists

With an asset allocation fund, professionals who study the markets can choose from a wider set of securities across sectors, industries and securities. This diversification may reduce your portfolio's overall risk and volatility.

Value

Many investment companies require that you invest a minimum amount of money. If you invest in several individual funds, you may need a significant amount of money to meet each minimum. With an asset allocation fund, you invest in many different kinds of assets for only one fund minimum.

Easier Money Management

It can be difficult to keep track of how you’re invested if your money is spread among different funds. An asset allocation portfolio gives you one place to check in on your portfolio.

Convenience

You make one investment choice with an asset allocation fund. Professional money managers construct the portfolio and decide how much of each asset it will hold. Then they manage the fund, including rebalancing when needed. There's less paperwork and recordkeeping for you to manage. Also, choosing one provider can make it easier when you buy or sell funds or do your taxes.

Are There Different Types of Asset Allocation Portfolios?

Generally, there are two broad categories of asset allocation portfolios:

Risk-Based Portfolios: Investors choose funds based on the amount of risk they want to take. Risk-based portfolios have a preset allocation and are periodically rebalanced to keep that allocation and risk level consistent, although the principal value of the investment is not guaranteed at any time.

Target-Date Portfolios: Investors choose portfolios by the approximate year they will need the money. Each year, the asset mix and weightings are adjusted to become more conservative as the target date approaches. The principal value of the investment is not guaranteed at any time, including at the target date.

What Affects an Asset Allocation Portfolio’s Performance and Risk?

The performance of an asset allocation portfolio depends on how the performance of all the underlying investments nets out. As with any investment, the value of an asset allocation portfolio will fluctuate and may fall below your original investment.

Of course, investing means living with some level of risk, including market risk. And depending on the types of assets held, there may be risks associated with investing in specific market sectors or securities. For example, many asset allocation portfolios include international securities, which expose investors to additional risks such as political instability and currency fluctuations. Investments in emerging markets may accentuate these risks.

How much risk is acceptable is up to the individual investor. There are risks associated with being too aggressive, and there are also risks related to being too timid. Learn more about the many types of risk and ways you may be able to manage them.

Building Your Future Block by Block

Managing your investments starts with understanding asset classes and asset allocation. Learning about investments’ past performance, their responses to different market conditions and their risks can help you build or choose a portfolio that takes into account your age, risk tolerance and goals for the future.

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