A basic understanding of asset classes will help you recognize the nature of various investments that are available to you to make.
If you want to build wealth, you need to figure out how to invest money. Which involves asking where to invest money.
The answer to this question of “where to invest money” will depend on your financial goals, your understanding of risk and reward and your appetite for risk.
The best way to reach your long-term financial goals, minimize risk and maximize reward when investing is to spread your money across different types of investments.
It is also important to understand what an investment is and the type of asset classes that exist.
An investment is an asset that you buy with the hope or belief that it will generate income in the future or it will increase in value in the future.
An investment can include bonds, stocks, real estate property, or a business. These investment types are called “asset classes”.
For example, you might choose to devote all, or nearly all, of your investment capital to trading futures or other financial derivatives such as Forex. But if you do, you must at least be aware that you have chosen to trade an asset class that is usually considered to carry significantly more risk than stocks or bonds or property.
If you’re serious about building your wealth, you need to consider all the asset classes that the investing world has to offer.
An asset class is a group of similar types of investments, that are usually traded together and are subject to the same rules and regulations. For example, shares, real estate and fixed-interest investments are all different types of asset classes.
It can be difficult to classify some assets because of the diversity of available investments which can create complications. Exchange-traded funds (ETFs), for example, trade on stock exchanges, just like stocks. However, ETFs may be composed of investments from one or more asset classes. An ETF that offers exposure to the energy market may be composed of investments in oil futures and in stocks of oil companies.
While there’s an argument about exactly how many different asset classes there are. Almost every type of investment or asset falls under one of these asset classes:
Stock (Equities): Stocks also known as equities are shares of ownership issued by public trade companies like Facebook and Apple. Essentially, you buy small portions of companies, called shares, with the goal of those shares becoming more valuable over time. This is one of the common ways of investing that people do.
Fixed-income investments (Bonds): Fixed-income investments are investments in debt securities that pay a fixed interest on your investment or capital over a given period, then return your capital at a set date. Debt securities allow a company or government to borrow your money to fund a project or refinance other debt. Such investments are generally considered less risky than investing in equities or other asset classes. Fixed income investments include bonds, money market instruments and CDs or what Nigerians call fixed interest accounts. Fixed income investments can offer a steady stream of income with less risk than stocks.
Cash or cash equivalents: The primary advantage of cash or cash equivalent investments is their liquidity. Money held in the form of cash or cash equivalents can be easily accessed at any time.
Forex, futures and other derivatives: This category includes futures contracts, spot and forward foreign exchange, options, and an expanding array of financial derivatives. Derivatives are financial instruments that are based on, or derived from, an underlying asset. For example, stock options are a derivative of stocks.
Real estate: Real estate and other physical (tangible) assets are considered an asset class that offers protection against inflation. The tangible nature of such assets also leads to them being considered as more of a “real” asset. Real estate is a way to diversify your investment portfolio outside of the traditional mix of stocks and bonds. It doesn’t necessarily mean buying a home or becoming a landlord — you can invest in REITs, which are like mutual funds for real estate, or through online real estate investing platforms, which pool investor money.
Infrastructure: A broad asset class that includes investing in highways, airports, rail networks, energy generation (utilities), energy storage and distribution (gas mains, pipelines etc. This asset class can protect against inflation, and reduce overall portfolio volatility
Commodities: This asset class involves physical goods such as gold, copper, crude oil, natural gas, wheat, corn, and even electricity. This asset class can help protect future purchasing power.
Alternative investments: This asset class is a group of investments that include collectibles, hedge funds or private equity investments (angel investing), and cryptocurrencies such as Bitcoin. These assets or investment types are a bit riskier. For that reason, they are sometimes classified together under the heading of “alternative investments”. Generally speaking, the more “alternative” an investment is, the more illiquid and the riskier it tends to be.
This is a broad list of asset classes but for the purpose of understanding asset classes, let’s classify asset classes into two types– defensive and growth.
Defensive assets consist of more stable investments with steadier returns. They’re less likely to lose money, and because they usually carry lower risk levels, defensive assets are more likely to generate lower levels of return over the long term. Types of defensive assets are Cash and fixed interest.
We usually expect defensive assets to provide returns in the form of income. For example, if you deposit money in a bank account, you may receive income as interest on the money deposited.
On the other hand, Growth assets have higher expected returns and the risks of losing money are higher, especially over the short term. Growth assets grow your investment over the long term. While they offer higher return potential, they are seen as higher risk investments because of their volatility, especially over shorter time periods of one to three years.
An increase in a company’s value is known as capital growth. A decrease is known as a capital loss. We generally expect growth assets to provide returns in the form of capital growth.
For example, as a shareholder of a company, you may receive income as dividends on the shares you own. However, most of the return usually comes from changes in the value of the company over time, as determined by its share price.
These returns are influenced by market fluctuations, so they can change a lot in the short term - this is known as volatility. Types of growth assets are shares, infrastructure/Private equity and property/real estate
You don’t really have to know for certain which asset class a specific investment falls into. You just need to understand the basic concept that there are broad, general categories of investments.
That’s why mixing up your investments and allocating the right amount of money to different asset classes, based on your risk profile is important. This process is known as asset allocation and diversification.
While spreading your money across different types of investments sounds easy enough, the hard part like always is in the doing. It is in deciding what kind of asset classes your should own.
Which we will talk about in the next email you’ll receive.
So stay tuned.
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