Understanding asset classes

Why understand asset classes

When you trade, you trade financial assets of one kind or another. There are different classes, or types, of assets – such as fixed income investments - that are grouped together based on their having a similar financial structure and because they are typically traded in the same financial markets and subject to the same rules and regulations.

There’s some argument about exactly how many different classes of assets there are, but many analysts commonly divide assets into the following five categories:

• Stocks or equities

• Bonds, or fixed income investments

• Cash or cash equivalents

• Real estate, or other tangible assets

• Futures and other financial derivatives

It’s difficult to classify some assets. For example, suppose you’re investing in stock market futures. Should those be classified with equities, since they’re essentially an investment in the stock market, or with futures, since they’re futures? Gold and silver are tangible assets, but are most frequently traded in the form of commodity futures or options, which are financial derivatives. If you invest in a real estate investment trust (REIT), should that be considered an investment in real estate or as an equity investment since REITs are exchange-traded securities? And as the chart below shows, simple investments in different asset classes clould impact your expected return.

Look at the chart, you can see that although emerging market equities has an expected return of over 5%. Its volatility is 27%. That is 20% more volatile than UK IG Bonds has an expected return of 2%. This means if you’d invested in emerging market equities, you could have received higher return on investment. However, you would also be investing in a riskier security.

Things are further complicated by the expansion in available investments. Exchange-traded funds (ETFs), for example, are traded like stocks on equity exchanges, but ETFs may be composed of investments from one or more of the five basic asset classes. An ETF that offers exposure to the gold market may be partly composed of investments in gold bullion and partly composed of stock shares of gold mining companies.

There are additional asset classes, such as artwork, various other collectibles, and peer to peer lending. Hedge funds and other sources of venture capital, along with markets that trade things such as Bitcoin and other alternative currencies, represent some other asset classes that are a bit more off the beaten path. Generally speaking, the more an investment falls into the category of “alternative investment”, the less liquid and the more risky it tends to be.

Whether you choose to invest in bitcoin, bonds or equities, or whether you prefer real estate, futures and other financial derivatives, is entirely down to you, your personality and areas of interest.

We will look at this in detail in the ‘Capital Markets, Trading and Investment‘ course, but for now it is important to note that there are many different types of traders with interest in different asset classes. And whatever your interests, skills or priorities, there is always an asset class that will suit you.

For the buying and selling of assets, there are several different types of markets that facilitate trade, and that’s what we’re going to start looking at in the next lesson.

LESSON SUMMARY

• There are different classes, or types, of assets – such as fixed income investments

• Expected returns and volatility impacts the attractiveness of an asset

• Your investment in a particular asset class is entirely down to you, your personality and areas of interest