In finance, investment products are divided into different categories called asset classes. What are asset classes, what are their key features and behaviors, and why are they so important to investors? Find out more in this explainer video.
Narrator: Categorization helps us better understand the similarities between things, types of fruits, vegetables, and other foods in a grocery store, for example. In finance, investment products are divided into categories called asset classes, according to their features and behaviors. So what are the main types of asset classes, and why are they so important to investors? This is Asset Classes: Unpacked.
Historically, three asset classes have widely been regarded as the most prominent. Cash and cash equivalents are the legal tender we use to make everyday payments. They might also be investments that can be easily converted into cash, such as bank certificates of deposit, commercial paper, or short-term bonds issued by corporations, and U.S. Treasury bills, with a maturity date of one year or less.
Cash and cash equivalents are highly liquid assets that can be accessed easily, and they are largely seen as a low risk, low return investment option. Equities also known as stocks are defined as shares of ownership in a company. Equities can be traded on stock exchanges, such as the New York Stock Exchange, NASDAQ, and the London Stock Exchange. Based on their performance over the past 20 years, equities tend to produce the highest investment returns over time. However, they also come with higher risk, as their value may rise or fall depending on factors, including the company's performance and investor demand.
Fixed income refers to investments in debt securities that provide fixed returns in the form of periodic payments. Common examples include government bonds, municipal bonds, and corporate bonds. Thanks to their predictable returns, fixed-income assets are usually considered less risky than equities. They are also sometimes combined with currencies and commodities under the umbrella term FICC.
Today, other asset classes include real estate, futures, derivatives, digital coins, carbon credits, and infrastructure. These are known as alternative investments. Certain alternative investments are fairly illiquid, which means they can't be easily sold or converted into cash, while others are traded on exchanges.
Alternative investments have become more mainstream in recent years and are increasingly used to diversify portfolios. This is because each asset class may perform differently under the same economic and market conditions. For example, gold has a low correlation with stocks, which means it may perform well, even during a bear market. Conversely, it may not necessarily offer high returns when the stock market is rising.
Building a diversified portfolio spread across a broad range of asset classes may, therefore, enable investors to reduce their overall risk exposure and stay invested, even throughout periods of heightened market volatility. All in all, each asset class has its own unique risk reward profile. As such, the way an investor divides their portfolio among different assets, a process known as "asset allocation," ultimately depends on personal factors, including their investment goals and risk tolerance.
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