The 4 Traditional Asset Classes: Investment Portfolio Basics
Updated: Aug 18, 2020
Stocks, Bonds, Cash, and Real Estate: All you need to know about 4 traditional assets
By definition, an asset class is a group or collection of similar investments that all share the same characteristics and all abide by the same laws. For example, stocks are their own asset class (known as equities). Today we’re going to take a look at these 4 asset classes:
Bonds (fixed income)
Cash (cash and money market instruments)
Learning about the different asset classes will help you in more ways than just gaining a little bit more knowledge. The key to long-term successful investing comes in the form of diversification. By educating yourself about these different asset classes and learning what your available options are, you will be just that much closer to building an amazing portfolio. Hopefully one that can withstand dips in the market and the test of time.
Traditional Asset Classes: Stocks (equities)
Whenever you buy stocks you are essentially buying a piece of ownership in a company. So, yes, technically if you bought a share in Alphabet then you can tell your friends that you’re a part owner of Google. Stocks come in many different shapes and sizes, but there are two main classifications:
Common Stock - Owners of shares of common stock can vote at shareholder meetings and will may receive dividend payments.
Preferred Stock - Owners of shares of preferred stock cannot typically vote at shareholder meetings, but they have a higher claim to earnings and assets than those holding common stock.
The price of stock changes essentially based on supply and demand. If a lot of people are buying stock in a certain company, that stock will go up. If a lot of people are selling stock from a certain company, then that stock will go down.
Stocks are not quite as good as cash, but they’re pretty close in terms of liquidity. Depending on your broker or brokerage platform (such as the trading app you may be using), it can be fairly easy to sell (liquidate) shares of stock during market-trading hours. The hardest part about liquidating shares of stock is waiting for your broker to deposit the funds into your bank account.
Traditional Asset Classes: Bonds (fixed income)
Bonds are known as a debt investment. Whenever an entity -- usually a corporation, government, or municipality -- needs to borrow money, they may issue bonds. They’re essentially just I.O.U. notes.
Banks and financial institutions can only lend out so much money. If the government needs to build a new dam and create some new roads, they can’t just call up Bank of America and ask for a loan. A 4-lane highway can cost $8million-$10million per mile, and that highway can’t exactly be used as collateral.
So they issue bonds. They tell investors that if they buy these bonds (loan them money) that on a certain date they will get their principal back plus interest. This interest is usually fixed, but can be variable as well.
There are many different types of bonds, some of the more common ones are:
Corporate Bond - Issued by a corporation
Government Bond - Issued by a government entity
Junk Bond - Has a high risk of default, but potentially higher yields
Investment-Grade Bond - Has a low risk, but lower yields
Liquidating your bonds won’t be quite as easy as selling stock. Bonds typically have a maturity date of when your original principal investment will be returned to you. Selling your bonds before this maturity date can result in you getting back less than what you originally put into it.
Because buying bonds is essentially the same as agreeing to loan a company money, there are strings attached when it comes to asking for your investment back before the agreed-upon date.
Traditional Asset Classes: Cash (cash and money market instruments)
Cash and cash equivalents describe pretty much what the name implies. Actual cash, or other extremely liquid assets that can be easily converted into cash such as:
Certificates of Deposit
Many budding investors are always shocked when they hear that cash and its equivalents are considered an investing asset class. Just because the returns aren’t that high and the risk is relatively low (which we’ll talk more about later on in the article), that doesn’t mean that these aren’t technically an investment.
Even if you’ve got the worst savings account in the world earning 0.00001% interest, putting money in there is still considered an investment. Aside from investing, cash and cash equivalents are usually used when determining the value of a company and its assets, hence why it’s listed as an asset class.
Traditional Asset Classes: Real Estate
Any piece of land or any structure on said land is real estate. Even though there are many different ways to invest in real estate, it still carries a very specific set of risks and rewards, and they’re governed by specific real estate investing rules. Because of this, real estate is in an asset class all on its own.
Real estate is one of the more illiquid investments out there. Even if you’re not directly investing in property yourself, but are going through an eREIT service like Fundrise, your money is usually locked in there pretty tightly.
Think about it. If you were to go purchase a piece of commercial property, you wouldn’t get your money back until you either re-sold it, or rented it out for a number of years. However, the potential for return is much greater than those assets that are a bit more liquid.
Asset Classes By Risk (and Reward!)
Now that we’ve got a basic understanding of the 4 traditional asset classes, let’s take a look at how they stack up next to each other. We’re going to rank them from the most risky to the least risky, and see how that correlates with their potential returns.
1. Real Estate
Of the 4 asset classes, real estate is arguably the most risky. Conversely, it also offers the best potential for consistently higher returns. The risks behind real estate investing are actually the driving force behind higher returns:
Risks vs. Rewards of Real Estate Ownership
Current and Future Interest Rates
Rental and Leasing Prices
Subject To Capital Gains and Losses During Direct Sales
Some forms of real estate investing carry more risks than others. Investing $1.2 Million into a commercial strip mall will carry more inherent risks than investing into an eREIT fund. What are some of the reasons investors choose the real estate asset class?
Potentially Higher Returns
Protection Against Inflation
2. Stocks (equities)
Although not quite as risky as real estate, there are still some risks involved when it comes to buying shares of a company. There is no guarantee that this company will grow and remain profitable. However, a diverse stock portfolio will oftentimes out-perform other investment classes like bonds and money markets.
Risk vs. Reward driving factors behind the value of stocks:
Potentially Higher Than Average Returns
Is Company Growing, Profitable, and/or Popular
Stocks are extremely subjective to emotional investing. The value and performance of a company can affect a stocks price, but greed and fear can drastically influence these prices as well.
3. Bonds (fixed income)
While the risk for most monds is relatively low, it certainly still exists. For most bonds, as interest rates rise, the bond prices can fall. Bond prices can also be influenced by inflation (which is arguably tied into the interest rates). A jump in interest rates doesn’t necessarily mean you will lose money on your bonds, however.
If you were to buy a bond that had a 2.5% coupon rate while the market interest rates were also at 2.5%, and then tried to sell your bond when market rates had risen to 3%, then you would get less on your investment than you would have had the interest rates stayed the same or dropped.
Having said that, the risks are still relatively low (the rewards are low too) when compared to stocks and real estate. And, sure, the company may default on the bond (since it is a form of debt, after all) but the corporations that issue bonds are usually giant conglomerates that are in no danger of failing.
4. Cash (cash equivalents and money markets)
The lowest risk of the 4 asset classes comes in the form of cash. Your money is pretty much safe, but the potential reward is inherently low when compared to other asset classes. Also, please don’t confuse extremely low risk with zero risk.
Even holding on to cold, hard cash has got risks involved. You can run the risk of inflation lessening the value of your cash. You run the risk of a bank going under and relying on their FDIC insurance to recoup your lost funds.
Despite the low potential for reward, it’s still a good idea to take advantage of this asset class. At the very least, having a nice cushion for unexpected expenditures can come in handy when you least expect it!
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