What is an “Asset Class”?
An asset class is a group of assets that have similar characteristics and behavior in the marketplace. Traditionally, the major asset classes are equities or stocks, fixed income or bonds (government and corporate), and real estate. In recent years, new asset classes termed “alternative asset classes or investments,” have emerged. These include commodities, cryptocurrencies, private equity, hedge funds, artwork, high-yield and emerging market bonds, among others. Such assets are highly illiquid and risky but can generate exceptionally high returns.
Key Learning Points
- The common types of asset classes are equities, bonds, and real estate.
- Correlation helps in measuring the relationship between the movement of prices of different asset classes. A negative correlation indicates that prices of two asset classes move in the opposite direction.
- Portfolio managers use correlations between asset classes for diversification and balancing the risks/rewards of portfolios.
Common Types of Asset Classes
Given below is a brief overview of the common types of asset classes:
Stocks, equities, or shares refer to buying an ownership stake in companies. As an asset class, stocks offer potentially high returns but they are also accompanied by a higher degree of risk. Within stocks, there are different sub-asset classes based on the following criteria:
- The market capitalization of the target company (e.g. large-cap stocks, mid-cap stocks, and small-cap stocks)
- Geography (e.g. US stocks, non-US stocks and emerging market stocks)
- Sectors (e.g. technology sector and pharma sector stocks)
Fixed Income Instruments
Fixed income instruments, such as bonds, offer a fixed return as per a fixed schedule. There are different sub-asset classes within bonds, such as government bonds (domestic and foreign), corporate bonds (investment grade and non-investment grade), etc. Bonds come with varying degrees of risks and rewards depending on the issuer. For example, bonds issued by the US government are less risky and offer lower returns than bonds issued by corporations.
Real estate is one of the oldest asset classes. There are multiple asset classes within real estate, such as residential, commercial, land, etc. Investors can buy these assets directly or invest in real estate through REITS (or real estate investment trusts). REITs own and operate income-generating real estate assets and allow investors to invest in real estate by buying shares of these companies without physically investing in properties themselves. Sub-asset classes of real estate include US real estate, real estate in emerging markets, etc.
Asset Classes and Diversification
Since asset classes differ in terms of rates of return, market volatility, risk factors, liquidity and taxation (among other factors), investors attempt to have a diversified portfolio that comprises of different asset classes which will earn maximum returns, while minimizing risks and costs.
Diversification works best when the asset classes are negatively correlated or uncorrelated. When two asset classes are negatively correlated, it means that when the price of one asset class falls (for example stocks), the price of the other rises (for example bonds) and vice versa.
Given below is information from a portfolio that invests in two asset classes – equities and bonds.
Generally, stocks and bonds have low or negative correlations. In the example above, we can see they have a very low correlation of 0.1. This means that any upward or downward movement in one asset class, say equities, will have very little impact on the other asset class (bonds).
In the above example, equities are expected to give a higher rate of return (19%), while bonds are expected to give a lower rate of return (8.0%).
Standard deviation represents the risks associated with each of these asset classes (the risk of price volatility). Equities have a higher standard deviation than bonds, consequently, they represent higher risk.
Weights represent the percentage of each asset class in the portfolio. This portfolio invests a higher proportion in bonds (64.0%) than equities (36.0%).
Next, given below is the calculation of the expected return of this portfolio using the sumproduct function in Excel. The function uses the expected returns of both asset classes and the respective weight of each.
The expected return on this portfolio is lower than the expected return on equities but is higher than the expected return on bonds. Investing the entire amount in equities can lead to higher returns, but accompanied by higher risk. Investing the entire amount in bonds can reduce risk, but the returns are also expected to be lower.
Investing in two (or more) different asset classes helps in balancing the risk and reward of this portfolio.