An asset class is a broad group of securities that react similarly in the marketplace, have similar financial features, and are subject to virtually identical laws and regulations.
There are three main asset classes: equity securities (stocks & shares), fixed-income securities (bonds), and money-market vehicles (cash equivalents). Many investors also include derivatives, commodities and real estate as asset classes.
The way investors spread their money in cash, bonds, equities, property and commodities – different asset classes – is their asset allocation. A conservative asset allocation consists mainly of property, bonds and cash, while a high risk one would comprise mainly shares.
Different asset classes are the building blocks of a diversified investment portfolio.
Understanding the features of each asset class helps people make better investment decisions. According to financial theory, if you invest in more than one asset class the risk to your portfolio is lower, but your overall target return is maintained.
Deciding which asset class to invest in
A popular way of determining how to diversify your investment portfolio is to use the age-adjusted mix.
With the age-adjusted mix you take your age, subtract that from 100. The result is turned into a percentage, with that proportion of the total portfolio being invested in stocks.
For example, if you are 40 years old, you subtract 40 from 100, which gives you 60. So, 60% of your money should be invested in stocks, while the rest should go into cash, bonds and property.
According to the Australian Investors Association, an asset class is:
“A category of investments that exhibit similar characteristics in the market place. The investments within a single asset class are expected to have similar risks and returns, be subject to the same laws and regulations, and perform in a similar manner in particular market conditions.”
Three main asset classes
Cash – includes all types of bank accounts and cash management trusts. This asset class is suitable for people with a short-term outlook, a low tolerance to risk, or during a volatile market.
Cash provides a stable and low risk income. There is no recommended minimum timeframe.
Fixed Interest – includes corporate and government bonds, mortgages and hybrid securities. A relatively stable class, but less so than cash. Income return is typically in the form of periodic interest payments for an agreed period.
The minimum timeframe for fixed interest investments are from 1 to 3 years.
Equities – include domestic and international stocks and shares. Returns generally include capital growth/loss, and income through dividends. This is the most volatile of all asset classes.
With equities, the investor becomes part-owner of a company and can share in its future growth and profits.
However, over long periods equities tend to achieve higher investment returns than the other main classes. Minimum timeframe is from 5 to 7 years.
No asset class is theoretically perfect. Choosing the right one depends on your needs and preferences, and not on which one is supposed to be better than the others.
Video – Understanding asset classes