Before you pick a single stock or fund, there’s a more important decision most investors skip entirely: which asset class it belongs to.

What is an asset class?

An asset class is a way to group financial assets that have similar qualities. For example, the US dollar (USD) and Swiss franc (CHF) are both currencies and can therefore be usefully lumped together. Among commodities, there are investments like gold and oil, while the equities class covers things like Amazon stock and Tesla shares.

Asset classes for diversification

Asset classes are one of the first considerations a new investor has to embrace. The idea is to develop a strategy that puts a certain percentage of your funds into different kinds of investments. This provides asset class diversification because each asset class behaves differently under different market conditions. In other words, currencies and equities can behave unpredictably in some economic situations, but the commodities portion of your investment portfolio might remain stable.

Similar investments tend to perform similarly; when the stock market in general is booming, individual share prices tend to rise, too. By contrast, there is usually little correlation, and sometimes even a negative correlation, between different asset classes. One classic example is the dollar-gold market: when the value of the dollar falls against other currencies, the gold price normally increases.

Fund managers as well as individual retail investors use this information to create diversified portfolios that can survive in both bull and bear markets. Furthermore, careful use of these asset classes can help an investor get exposure to a fund-like structure while still maintaining control over their own portfolios. In this way, individuals can choose to emulate traditional vehicles, like most ETFs and mutual funds, or choose a portfolio reminiscent of hedge funds, which include more alternative investments.

What are the five major asset classes?

The starting point for all investing is to select a proportion of your total nest egg to place into each, or some, of these five general types of assets. For those who prefer a relatively hands-off approach, there will probably be little need to look very far beyond the first three for profitable ways to store your money. 

• Cash
• Equities
• Bonds

Cash, bonds, and equities are all very liquid and, between the three of them, offer risk diversification as well as numerous individual investments. Within the stock market, for instance, you may select a basket of equities ranging from large-cap, blue-chip companies to high-yield, somewhat volatile growth shres to income-earning dividend stocks. 

Cash investments are the safest but also offer the lowest returns. Equities are risky in the short term but have historically offered the best returns over several years. Bonds, meaning fixed-income debt owed by governments and companies, fall somewhere in the middle.

More experienced or ambitious investors may also want to search further afield for money-making opportunities in:

• Property
• Commodities

Commodities are very speculative and tend to require expert knowledge. Anyone who wants to trade cacao futures, for instance, will have to track currency movements, long-range weather predictions, geopolitical events, and more. Property, being “safe as houses” by reputation, is an excellent addition to any portfolio, offering both reliable income-earning and capital gains potential. However, this market has higher barriers to entry and is more illiquid. Buying only part of a house or apartment building is complicated, and it’s hard to quickly find a buyer if you need to cash out.

For most investors, these five types of assets will make up the bulk of their long-term portfolio. This categorisation isn’t set in stone, though, nor is it meant to be comprehensive. As a retail investor, you may possess specialised knowledge that allows you to invest in rare coins, a small business, or something else under the “alternative” umbrella, meaning not part of a traditional asset class. There is also more than one way to slice a cake. Different investors split assets up into different classes, depending on their need for diversification and return, as well as the sophistication of their trading activity. Fund managers, for instance, generally make a distinction between domestic and global equities and treat these as different asset classes.

Weighing risk against return over different asset classes

Asset classes are distinct types of investments that behave similarly under the same market conditions. One advantage of structuring your investment thinking this way is to use them as a kind of shorthand: “to go long on equities” means to have confidence in the stock market. 

It’s also beneficial to think of each class as a family of securities that share a broad range of attributes. Each asset class, for instance, has its own unique risk and return characteristics. Since handling commodities and the various derivatives based on these requires considerable knowledge, let’s focus on equities, bonds, money market instruments, and real estate.

• Equities: These are high-risk investments, especially if you’re not a buy-and-hold investor. On the other hand, stocks also provide high returns. Their performance is primarily influenced by the financial health of the particular company and the overall economic climate. 
• Fixed-income bonds: These investments carry less risk than equities, though there is considerable variation within this class (U.S. treasuries vs junk bonds, for example). They offer fixed returns, making them suitable for conservative investors.
• Money market instruments: These are very low-risk investments. They offer modest returns and are highly liquid, making them a popular place to park cash until a better use can be found for it.
• Real estate: This asset class can be risky depending on the location and market conditions, but it can also provide high returns. Since different properties aren’t interchangeable, these investments have to be entered into and managed with considerable care. Investors who cannot afford whole commercial or residential properties commonly put their money into real estate investment trusts (REITs).

Asset allocation

It’s well and good to know, for example, that bonds are generally a safer investment than stocks, and that money market instruments are prized for their ability to be quickly converted into cash. This is not enough, however, for you to create the ideal asset allocation portfolio. While smartphone apps and investing websites’ ease of use make it easy to buy and sell securities in most asset classes with the touch of a button, smart investors understand the differences between them, where they come from, and what role each plays in the modern economy. 

Investing in stocks

Also called equities, stocks are ownership rights in small chunks of cash-flow-producing entities – that is, companies that generate value over time. Some kinds of businesses, like steel mills and railroads, are too large and expensive for any individual or partnership to finance on their own. So, possession is split into thousands or even millions of fractions. These shares can change hands without affecting the day-to-day management of the company and are traded on a public stock exchange like the London Stock Exchange.

Each share is a contract of ownership in a fraction of a company’s assets and profit; some kinds of shares also allow the owners to have a say in strategic decisions made by the managing board. Since these shares are publicly traded, anybody can become a part-owner of a company. This does not apply to all large corporations, though: some famous names, like IKEA and Koch Industries, are not public companies and do not have their shares listed on an exchange. Private companies, including startups that require a capital infusion to grow, may become public companies by filing for an initial public offering. Also, companies that are already public, like Tesla and Amazon, may become private once again. 

Within this asset class, there are various sub-categories of stocks, like blue-chip firms (large, established companies) and small caps (emerging or niche businesses). Most equity investors prefer to spread their portfolios over various industries and types of stocks.

Fixed-income investing

Fixed income means an income that recurs predictably over a long period of time. When talking about bonds, this refers to a pre-set payment made to the owner at intervals. The concept behind fixed income securities is simple: lend your money to a business or government in return for periodic interest payments. Money market instruments such as federal agency notes and treasury bills are good examples. As with shares, this process is not affected by who holds the bond, so these can be traded on an open exchange.

It’s possible to swap money you have today for more money in the future because of a phenomenon called “the time value of money”. Someone who borrows a dollar in order to finance projects that increase in value can afford to pay their lender more than a dollar once those projects mature. The increase, expressed as interest, is the sum to be paid for its use.

Bonds are just a formalisation of that principle. Imagine a piece of paper from the government or a corporation that states that, in return for lending them $1,000 today, they will pay you $25 every month for three years and that, at the end of those three years, you will get your $1,000 back.

The “fixed income” part is therefore the regular interest payments made until the bond’s “maturity date” is reached. These bonds typically run over the medium to long term, while other assets, such as money market funds, lend out money in the short term. When all these are combined, we can speak of a debt market, in which obligations to pay back loans are monetised and traded. In fact, this market is larger than the equities market.

Forex trading

“Forex” is an abbreviation for “foreign exchange”; it refers to the global marketplace on which investors can buy and sell different national currencies. You can buy American dollars with Japanese yen and then sell those dollars and get Swiss francs in return. The goal of forex is to make profits on price differences between currencies as they change over time.

This is a huge market, and the biggest in terms of trading volume. Though there are dozens of tradeable currencies, the majority of transactions take place between the U.S. dollar and another major currency: the euro, pound, yen, franc, and the Canadian and Australian dollars.

The point behind trading currencies is that the relative values of these go up and down depending on a plethora of political and economic factors. These include changes in a country’s money supply, trade dynamics between countries, and differences in central bank interest rates. A shift in any of these produces opportunities for speculation, and the forex market is open twenty-four hours, five days a week. 

Trading indices 

If you often hear phrases like “The Dow is up,” you probably have some sense of what an index is. More specifically, an index is a broad signal of the performance of a sector or market. It is usually calculated as a weighted average of the prices of a conglomerate of prominent stocks.

The S&P 500, for example, is composed of 500 companies. As the value of an index is expressed as a single number, it allows market participants to quickly gauge the current stock market climate. There are a variety of indices that represent different sectors, such as the Russell 2000 Index, the main focus of which is small-cap stocks (companies with small market capitalisations and low total valuations).

The famous Dow Jones Industrial Average is used as a proxy for determining the general health of the U.S. economy. Indices like these are what media pundits are alluding to when talking about “the markets”. In terms of practical trading, indices are helpful as a yardstick for measuring the performance of actively managed funds, which often claim to “beat” the return of the market index. Indices can also be traded in the form of ETFs that mirror the makeup of those indices, or as slightly exotic instruments like index CFDs.

Investing in mutual funds

Mutual funds are often associated with retirement accounts managed by employers. The idea was, in its time, ingenious: by combining the capital of multiple small investors, their shared portfolio of stocks, bonds, or other assets can be professionally managed while the transaction costs each would have to pay are also reduced. The latter point is less pertinent in the age of online trading, but mutual funds remain a good option for hands-off investors.

While all mutual funds are diversified to protect their members’ money, they focus on different asset classes:

• Equity funds keep most or all of their money in stocks. Some track an index, not aiming to outperform the market, while others may be devoted to a specific industry like technology or healthcare, or are limited to certain geographic regions.
• Bond funds specialise in bonds and other debt securities. In line with their fixed-income philosophy, they make regular payouts to investors.
• Money market funds also invest in debt, but in short-term, high-quality securities rather than long-term bonds. Though the returns are not stellar, money market funds are very safe.
• Balanced or hybrid funds do not restrict their managers to buying either stocks or bonds but invest in a mixture of asset classes in order to provide their members with an acceptable risk-and-return profile.

Investing in ETFs 

Exchange-Traded Funds (ETFs) are similar to mutual funds, though there are some significant differences. Most importantly, ETFs issue shares in themselves, which can be traded on public stock exchanges just like the companies they invest in. ETFs are therefore more liquid, whereas mutual fund units can only be bought or sold once a day, and withdrawals sometimes carry high fees.

ETFs offer more variety than mutual funds. In addition to the investment strategies associated with mutual funds, some specialise in commodities like gold or oil (perhaps trading both futures contracts and producers’ stocks), others pursue themes like clean energy or artificial intelligence, a few trade forex, while some claim to follow proprietary investment protocols that deliver consistently high returns.

Commodities trading

Whatever physical object can be sold is technically a commodity. In financial markets, though, we typically use the word to refer to assets that are fungible (interchangeable) and traded in large volumes on a global scale. Some examples are petroleum oil, soybeans, beef, iron, and gold. Many commodities are basic feedstocks for industry, while others, like precious metals, are considered to have intrinsic value.

Commodity prices fluctuate frequently. They are also largely uncorrelated with stocks, meaning that allocating some of your portfolio to this asset class helps with diversification. Most retail investors prefer to gain exposure to the commodities market by investing in an appropriate ETF, perhaps the Harbor Commodity All-Weather Strategy fund. Trading futures contracts based on commodities, as described in the next section, is somewhat more complicated, as discussed next.

Futures and options trading

Options and futures are both contracts regarding the sale of some financial asset – an equity, commodity, or whatever – at some date yet to come. Futures impose an obligation on both buyer and seller: the item has to change hands at a certain price on a certain date. 

Options, as the name implies, are more flexible. The holder of an option can choose to exercise it or not. This implies that an option to buy (a “call”) is taken out as a bet that the asset’s price will fall; once this price is below the contract value of the option, it is “in the money”. Conversely, a “put” option allows the one who possesses it to sell a security at the option price instead of the market value and is an example of “going long” (anticipating an increased price) on that asset.

Futures are only executed on the date the contract sets for the transaction, while most options can be exercised will at any time before the expiry date. In addition, options cost money: the entity that issues them charges a premium based on the perceived risk of them being exercised.

More importantly, both options and futures contracts become tradeable financial instruments as soon as they’re issued. A thriving secondary market exists in both, in which they are sold again and again as real-time information affects their prices.

Cryptocurrencies

Cryptocurrencies like bitcoin, ethereum, and whatever meme coin was launched last week, are considered as an asset class separate from cash and cash equivalents. This makes sense: crypto is highly volatile and not backed by any physical commodity, government, or central bank.

These digital assets can be traded on exchanges like Coinbase or many online investing platforms. Some ETFs and public companies also offer exposure to specific coins or crypto in general.

Some traders do dabble in crypto, even seriously, as a hedge against fiat currency instability or as pure speculation. There is a good chance of losing much of your investment, though, so this asset class should be treated with extreme care.

Real estate investment

Houses, shopping malls, apartment complexes and other forms of real estate have two major things going for them: while they almost always appreciate in value, they also generate consistent profit in the form of rent. On the other hand, unlike most investments, real estate requires considerable hands-on management and involves maintenance expenses. Real estate remains popular, however, due to stable or appreciating values and the possibility of high profits.

There are a few ways to invest in real estate:

• Direct ownership requires purchasing residential or commercial properties directly, perhaps using a mortgage as financing. The property is then rented out and, some time later, sold for capital gains.
• Real Estate Investment Trusts (REITs) are companies that own and manage income-generating properties. They are, in effect, specialised ETFs. 
• Real estate funds are the mutual-fund equivalent to REITs and may invest in companies and REITs that hold real estate in addition to running their own properties. This strategy offers members the benefit of diversification due to the larger number of properties involved. 

Private equity investments

As mentioned earlier, “public” companies are those whose shares are traded on stock exchanges and can be bought by anyone. Private companies are not quite as easy to invest in…but this also means that greater opportunities are available to those willing to do the legwork.

Private equity just means investments in private companies. When it comes to venture capital, this takes the form of investing in small companies with high growth potential – startups – perhaps in the hope of taking them public later and making enormous profits. In some cases, a public company may be taken private by buying all outstanding shares and delisting them from the stock exchange. These buyouts are often leveraged, meaning that shareholders are paid by money borrowed against the business itself. In either case, the new part-owner generally gets a meaningful say in the management of the business.

Private equity funds allow retail investors to pool their funds, somewhat like mutual funds do. However, like hedge funds, they generally allow only “sophisticated investors”, i.e. high-net-worth individuals, and institutions to join. In addition, high minimum investment amounts make private equity funds inaccessible to most people.

Alternative investment strategies

While all assets falling outside the five main asset classes are typically called “alternative”, alternative investment strategies usually refer to investing in financial instruments other than stocks and bonds. These (including when they’re repackaged in an ETF or mutual fund) are the go-to options for most retail investors.

Some, though, are interested in less traditional methods that can achieve higher potential returns, even though the risks involved may be greater. Fortunately, the downsides can be mitigated by diversification, or investing only a limited portion of your total portfolio in vehicles like the following:

• Hedge funds: These are usually only accessible to accredited investors and use a range of strategies like short selling and leveraging to generate returns well over that of the stock market.
• Real estate: Buying property either directly or through Real Estate Investment Trusts (REITs).
• Private equity: This can take the form of investing in a fund that takes positions in non-publicly traded companies or buying a stake in a small business.
• Commodities: These are physical assets including gold, oil, and agricultural products. Most commodity investments are made in derivatives backed by these assets or in companies that deal in them.

Understanding asset class liquidity

While the risk and reward implied by different asset classes are a long-term investor’s main concerns, it’s also a good idea to consider liquidity: the ease with which an asset can be bought or sold at its current market price. Private investors often find themselves facing the choice of either cashing out some of their holdings or taking out a loan. In this case, they’re in a good position if they have some assets that are not only profitable but also liquid.

Cash and cash equivalents are, naturally, the most liquid assets as they can be easily converted into other forms. This isn’t absolute, though: cashing out a Certificate of Deposit (COD) or similar instrument before it matures does mean paying a penalty.

On the other end of the scale, assets like real estate or private equity are very illiquid, as they take longer to sell for cash unless you’re willing to accept a lower price.

Factors affecting asset class liquidity include:

• Market conditions: When markets are volatile and prices fluctuate rapidly, liquidity is lower as buyers find it harder to determine a fair price for assets.
• Asset type: Some assets are just inherently more liquid than others. A popular stock may see thousands of shares changing hands per hour, while buildings and art take more time to sell.
• Economic factors: Economic downturns generally lead to decreased liquidity, especially for riskier assets, as investors adopt a more defensive posture.

The impact of economic conditions on different asset classes

If you’re a long-term investor, it doesn’t make much sense to dump a stock you own just because it had a single bad month – most likely, it will recover its losses and more. However, it is necessary to rebalance your portfolio from time to time, especially if the health of the economy has changed. Asset classes provide a framework for generating a first approximation of where your investments should be placed in order to provide decent returns without sacrificing reasonable safety:

• Interest rates: When interest rates rise, bond prices tend to fall. This happens because fixed-rate bonds that have already been issued become less attractive than newly minted debt instruments. Conversely, when interest rates fall, bond prices usually rise.
• Inflation: Inflation erodes the purchasing power of money over time, which will negatively impact the real return of all of your investments. Cash equivalents and bonds are most affected, stocks less so, while offshore holdings (including foreign currencies) can actually gain in value
• Economic growth: Strong economic growth boosts corporate profits, leading to higher stock prices. However, rapid growth can also lead to inflation and higher interest rates.
• Political stability: Political instability can increase uncertainty, leading to higher volatility in financial markets overall. If possible, it’s generally a good idea to own some assets in a different, stable region of the world for diversification purposes.

Managing asset class correlation

“Asset class correlation” refers to how different asset classes move in relation to each other. Positive correlation implies that they tend to move in the same direction because changing economic conditions affect them in similar ways. If the oil price rises or falls, for example, the same happens to the companies that trade, extract, or refine petroleum. In fact, all companies in the broader energy sector tend to be affected in the same way.

If they’re negatively correlated, they move in opposite directions. Airlines, for instance, don’t profit from higher fuel prices; their costs go up instead. Owning too many positively correlated assets means that your gains will be amplified, but the same will be true of any losses. Diversification therefore requires you to combine asset classes with low or negative correlation in order to reduce risk. Some terms to know in this regard include:

• Diversification: Investing in a variety of assets and asset classes, instead of going all-in on one sector, reduces the risk that poor performance in one economic arena will ruin your overall portfolio.
• Rebalancing: Periodically reviewing and adjusting your portfolio to maintain your desired risk profile and adjust for market changes.
• Asset allocation: The process of dividing your investment portfolio among different asset classes, as dictated by your investment goals, risk tolerance, and investment horizon.

In conclusion

There is nothing wrong with investing exclusively in stocks and bonds, or even a single ETF, as many people with an eye on retiring comfortably do. Stepping outside this limited circle increases your level of exposure, especially if you don’t also take the time to research new asset classes and figure out how they work. 

As your knowledge and net worth start to increase, though, it begins to make sense to at least be aware of opportunities like real estate, forex, and commodities. If you choose to reject these asset classes as being too risky or too much work, so be it. However, you may also discover a knack for trading these part-time, an undertaking that can be both profitable and rewarding.