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Anita Sonawane:

What are asset classes?

Ryan Feit:

Before you invest, you have to know which asset classes you're going to consider investing in. But what exactly are asset classes?

Dexx Jordan:

An asset class is a group of investments that exhibit similar characteristics, perform competitively in the marketplace, and are governed by the same laws and regulations.

Anita Sonawane:

Although there is some debate about how many asset classes there are, historically, there have been three types-- stocks, also called equities; bonds, sometimes called fixed income; and alternatives, which include hedge funds, private equity, venture capital, and real assets.

Ryan Feit:

Let's start with stocks. Simply speaking, a stock is a form of ownership in a company. Let's say you purchase stock or shares in a company-- in Apple, for example. That means that a small portion of Apple belongs to you. This ownership entitles you to three key things. The first is profits.

If Apple ends up doing very well and generating a profit, it might decide to distribute a portion of those profits to you in the form of a dividend. Many people will reinvest the dividends in the company to increase their ownership, as well as their dividend income over time. The more shares you own, the more dividend income you receive. Sometimes, rather than paying dividends, a company could decide to take its profits and then reinvest them in the business, which makes your ownership share potentially more valuable.

Another thing your ownership stake entitles you to is voting rights. In other words, you can have a say in certain company decisions, like who sits on the board of directors who lead the company. And the third thing, because you are a partial owner of the company, you own a portion of all the things the company owns or the company's assets. However, if the company hits tough times and has to sell some of its assets, the proceeds will go to its creditors or bondholders before they would get to you.

Historically, stocks have been a very good long-term investment. There's actually never been a 20- or 30-year period in the history of the US stock market where stocks have not generated positive returns. But there's a drawback. And that is, stocks can lose money over the short term.

So when investing in stocks, think for the long term. Don't invest money that you think you're going to need in the near term.

Dexx Jordan:

The next asset class is bonds. You have corporate bonds, asset-backed bonds, and government bonds. But at its core, bond is pretty simple. When you invest in bonds, you're essentially lending money to an organization, and that organization in turn gives you back a note.

Think of it as an IOU, where they say that they're going to pay you back that initial investment at the end of some period, plus interest along the way. So let's say that you invested $100 in the organization. They might say, we'll pay you $3 payments every six months for five years, and then at the end of that, we'll pay you back your original $100. Now, this organization can be a corporation, like Microsoft, or it can also be like the US government.

Usually the bonds of large, stable governments tend to do well in tough times, and here's why. Let's say the stock market is falling and companies are really hurting. Well, suddenly, a fixed payment from a big, stable government that has the means to pay you back is a lot more attractive. And it makes bonds more attractive, which cause the prices to go up.

But there's a drawback to bonds. They don't tend to do well in inflationary environments. Let's take that same example from earlier of the $100 bond you're getting, those $3 payments every six months. Well, in inflationary environment, that $3 can buy you less and less over time.

So those fixed payments actually can be a disadvantage.

Anita Sonawane:

The third asset class is alternatives. This is a bit of a catch-all category for things that don't fit into the traditional asset buckets, for example, things like hedge funds, private equity, and venture capital. Alternatives also include hard assets, like real estate, infrastructure, and commodities. Alternative investments offer a range of potential benefits, including a low correlation to stocks and bonds.

Unlike stocks and bonds, commodity prices tend to rise when inflation is accelerating. Why is that the case? Basically, when the demand for a good increases, the price of that good rises, as does the price of the commodities or inputs used to produce it. On the other hand, commodity prices can be very volatile, going up or down quickly based on macro or geopolitical conditions.

Some types of alternative investments, like private equity or venture capital, may offer the potential for higher returns. Although, this comes with greater investment risk. This is why investors need to meet certain suitability requirements to invest in these types of assets. So to recap, we've touched on three basic asset classes-- stocks, which can be good for long-term growth but volatile in the short term; bonds, which can offer stability but suffer in inflationary periods; and alternative assets. They can improve diversification and some can hedge against inflation. The next question to ask is, how do you determine which asset classes to own and in which proportion? We discuss that in our video on asset allocation.

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