Asset Classes Defined
Charles Rotblut will speak at the 2015 AAII Investor Conference this fall; go to www.aaii.com/conference for more details.
Combining various asset classes in a portfolio to achieve a higher return while lowering risk is a good strategy, but only if you know what you are investing in. Each asset class has unique characteristics that influence its price volatility and level of risk. In this month’s column, I define the major asset classes and explain what factors influence their returns and what risks they carry.
Though each asset class is not without risk, when grouped together in a portfolio, their individual characteristics offset overall investment risk and enhance long-term returns.
Stocks are ownership interests in a company. They are often called equities because shareholders own the net assets of a company, which is also known as “equity.” As partial owners, shareholders have the right to vote on corporate matters and receive dividends.
Stock prices are primarily influenced by earnings, and the market’s expectation of what future earnings will be. A variety of other factors can also affect a stock’s price, including valuation, the economic environment, industry conditions, sentiment, news headlines, and changes in the number of shares outstanding.
Stocks are more volatile than bonds, but have historically provided higher long-term returns. It is possible to lose a significant part or all of one’s investment in a stock. Also, in the event of bankruptcy, bondholders are paid before shareholders.
A bond is a promissory note issued by a company or government entity. It is a loan with a specified date for full payment (the maturity date). Bonds are referred to as “fixed income” because the rate of interest is typically set and investors can expect scheduled interest payments over the life of the bond.
Since bonds typically have a preset interest rate, their prices move inversely to interest rates. When interest rates rise, bond prices fall because investors do not want a lower-than-prevailing level of interest. Conversely, when rates fall, bond prices rise. Bonds with longer maturities are more volatile because of uncertainty about future interest rates.
While bonds have comparatively less risk, potential pitfalls include credit quality and the risk of default. There is also reinvestment risk—the chance that once the bond matures, prevailing rates will be lower than the interest rate received on the old bond.
Commodities are assets that can be grown, raised, drilled or mined. This asset class includes agricultural products (e.g., grains), metals (e.g., copper), and energy (e.g., oil). Commodities can be purchased either directly or indirectly through a fund or a futures contract. (The latter is an agreement to purchase the commodity on a future date at a specified price.)
Commodities do not provide any income stream. Rather, their value depends on what a buyer is willing to pay. Commodities are perceived as a hedge against inflation, since their prices should rise as the value of a dollar weakens. However, supply and demand, as well as other factors, can prevent commodities from rising in reaction to higher inflation.
Commodities are very risky, and it is possible to lose all of one’s investment—this is particularly true with futures.
Real estate includes land and buildings, both residential and commercial. Real estate can be purchased directly, though many investors opt for real estate investment trusts. If real estate is rented or leased, it can provide an income stream. However, the cash flow is offset by expenses such as maintenance, repairs and taxes.
A direct investment can require a significant amount of cash and involves high transaction costs. A REIT is easier to buy and sell, but offers fewer diversification benefits relative to stocks. All real estate is affected by the economy, interest rates and location. The risk varies by the type of property and location, and it is possible to lose all of one’s investment.