What is an Asset Class?

An asset class is a group of securities that share similar return and risk characteristics. When it comes to investing, there are three primary asset classes most people invest their money into; cash, fixed income, and equity. More non-traditional asset classes are available today, but most investment portfolios consist of these three traditional asset classes (cash, fixed income, and equity). To invest, you first must understand each asset class and their respective risk and return profiles.

What is Cash Asset Class?

The cash asset class has the lowest risk profile among the three asset classes. Its low-risk profile is a result of its low expected return, which is the lowest among all asset classes. Cash offers security in seeing your money daily but can be detrimental to long-term growth as inflation erodes your purchasing power each year. Inflation is the invisible thief we never see, and while cash might make you feel good, it damages your purchasing power. That being said, cash can play an important role within an investment portfolio when incorporated as part of a holistic financial and investment plan.

What is a Fixed Income Asset Class?

The fixed-income asset class is riskier than cash but will likely generate a higher return than cash. Bonds are the most common fixed income security investors have in their portfolios. Fixed income assets can be subdivided further based on credit quality, term maturity, or geography, to name a few. Bonds are usually held in a portfolio to offset some of the risks associated with holdings equities or reduce the portfolio’s overall volatility. In a simplified explanation, the more fixed income you have in your portfolio, the lower the portfolio’s overall risk profile. An investment portfolio that consists entirely of fixed-income securities would likely not make sense for a young person. That’s based on the assumption that a young investor probably requires their investment to grow over time given their investment period. Debt securities (another name for fixed income asset class) do not offer as much growth potential as equities but are an important class for a well-rounded portfolio.

What is an Equity Asset Class?

The equity asset class offers the highest possible return of all the asset classes but has the highest risk profile. Similar to fixed income, equities can be further subdivided into smaller groups based on investment style, geography, or market capitalization. Equities are an important asset class to have in your portfolio because it’s where you can generate the greatest return. Equities provide an opportunity to grow an investment over the long term but also have the greatest volatility among the asset classes mentioned.

Putting all the Asset Class Together

Creating an investment portfolio is like making a pie. A good pie is the result of all the ingredients being mixed in the optimal proportion to each other. Asset classes are the ingredients for creating an investment portfolio. The mixing of asset classes is known as asset allocation.

Asset allocation is the process of figuring out how much of each asset class (cash, fixed income, and equity) you should have in your investment portfolio to generate the return you require to meet your goals while ensuring it also suits your risk profile.

It’s a delicate balancing act because you might require a 10% rate of return but are not comfortable with taking the type of risk required to get a 10% rate of return. Your risk profile plays a big part in determining how much stock, bonds, or cash you will have in your investment portfolio. Knowing how each asset class expected returns and risk profile enables you to construct an investment portfolio that will suit your risk profile while allowing you to meet your investment goals.