An investor’s guide to asset classes: Types, allocations & more

You've probably read or heard investment guidance about the importance of having the right mix of assets, but what exactly does this mean? What are the different asset classes?

One of the first steps in building a portfolio is to determine the best combination of assets for your risk tolerance and financial goals. The right formula is different for every investor, and understanding how each asset class functions will give you greater clarity when it comes to investing.

An asset is anything of value that can be owned. In the investment universe, an asset generally refers to one of the three primary asset classes, which are equities (stocks), fixed-income (bonds) and cash (or its equivalent). Every investor should be familiar with these types of assets when considering an investment strategy.

In addition to understanding what assets are, it's also important to be aware that each asset class has unique risks and potential for return. It's smart to consider them all as you decide on specific investment types within the asset classes.

A company's equity is the amount of money that would remain if the company liquidated everything it had and paid off all its debt. Stocks—also referred to as equities or equity investments—represent ownership in a company. When you buy shares of stock in a company, you become a part owner. You, as an investor shareholder, participate in the company's profits through share value appreciation and any dividends the company may pay.

You can invest in equities directly by purchasing individual shares of stock or indirectly by investing in mutual funds or exchange-traded funds (ETFs). Mutual funds and ETFs are similar in that they are like baskets that hold multiple securities—such as stocks or bonds—in a single package.

A key difference between mutual funds and ETFs is that ETFs trade intraday on an exchange like individual stocks while mutual funds trade at the close of the market. To purchase shares of these equity investments, you need a trading account, such as a standard brokerage account. You also may purchase investments through a financial advisor.

Fixed income is an asset class or investment security that represents a loan. The issuer generally pays a fixed interest rate over a fixed period of time. The most common example of fixed-income investments are bonds. When you purchase bonds, you become a lender to the issuing entity, which is the borrower. Bond issuers are often governments, municipalities or corporations.

When you buy a corporate bond, you are loaning money to a corporation, which will use that money as capital for its daily operations and projects. In return, you receive a set amount of interest for a certain period, typically twice a year for one to 30 years. On the maturity date, you get back the principal amount (the original amount invested).

The most common ways of investing in fixed-income assets are by directly purchasing individual bonds—from the issuing entity or via a brokerage account—or indirectly by investing in a mutual fund or ETF that has bonds in its mix.

Cash and its equivalents are the most liquid assets. This can include any cash and similar items used for short-term financing needs. Cash equivalent debt securities typically have maturities of fewer than 90 days. Examples include:

• Checking and savings accounts
• Certificates of deposit (CDs)
• Money market funds
• Treasury bills
• Treasury notes
• Commercial paper

You can purchase these types of cash equivalents through a brokerage account, directly from the U.S. Treasury or from a bank. You also may hold cash and equivalents indirectly through mutual funds, which may have a mix of any or all three asset types as a means of diversification or meeting distributions and buying new securities.

The most common way for individual investors to invest in cash equivalents is through a money market fund, which typically holds a diversified mix of short-term fixed-asset investments in its portfolio, such as Treasury bills and notes and commercial paper.

The differences between equities, fixed-income assets and cash primarily involve the degree of market risk associated with each and the expected return or rate of interest received by the investor over time. For example, stocks generally produce higher long-term returns than bonds or cash, but the risk of losing any portion of the principal amount invested is greater than that of bonds and cash.

• Equity assets: Compared to fixed-income and cash assets, equity assets are riskier but also offer high potential returns over time.
• Fixed-income assets: Compared to equity assets, fixed-income assets offer lower risk and lower return, but they have a higher risk-and-potential return profile than cash assets.
• Cash and cash equivalent assets: Compared to equity and fixed-income assets, cash and cash equivalents are lower risk but average the lowest returns over time.

The riskiest asset types typically include stocks, especially individual stocks, and some bond types, such as high-yield, high-risk debt known as junk bonds. While they offer the potential for high returns or higher yields, the riskiest investments in this category also come with significant volatility and the risk of losing your entire investment.

The safest, lowest-risk investment assets are typically certain types of fixed-income, such as Treasury bills and diversified bond mutual funds, and types of cash, such as money market funds and certificates of deposit (CDs).

Equities, which includes stocks, stock mutual funds and stock ETFs, generally offer investors the highest potential returns over time while presenting the highest risk of loss. Remember that investing has risk, including the potential to lose your principal.

Although past performance is no guarantee of future results, history can be a good guide for expectations on long-term rates of return. Over a 10-year period:

• Equities (as measured by the S&P 500 Index) average around 10%.
• Fixed income (Treasury bonds) average between 4-5%.
• Cash and equivalents (Treasury bills) average just over 4%.
  

Liquid assets, like stocks or savings accounts, easily can be converted to cash. Illiquid assets, such as real estate or collectibles, take time to sell and might lose value before you can sell them.

Choosing the "right" type of assets depends on a few personalized considerations, including risk tolerance and time horizon:

• Risk tolerance. This aspect measures the degree of risk you're willing to take to achieve an investment goal. Financial professionals often gauge this with a questionnaire about investment scenarios. For example, knowing how you may react if stock prices were to fall 20% over one month helps determine your tolerance for risk.
• Time horizon. This is how long you plan to hold your investments. For example, if you are 40 years old today and want to retire and begin making withdrawals from your investments at age 60, your time horizon is 20 years.

These are among the determinations financial advisors make when engaging in the financial planning process or providing specific investment recommendations.

As you build a portfolio of investments, one of the primary goals is to end up with a diversified mix of two or three of the main investment asset types. Asset allocation refers to the mix of asset classes, such as equities/stocks, fixed-income/bonds and cash or equivalents, included in a portfolio. You might hear "asset allocation" referring to an individual's investment portfolio or the portfolio of a managed pool of assets, such as a mutual fund.

Asset allocations are commonly categorized in ways that refer to an investment objective. There are three: growth, growth and income, and income and principal preservation. Sometimes these also are called aggressive, moderate and conservative, respectively, and may describe an investor's risk profile.

• Aggressive asset allocation. Also called a growth objective, this allocation is generally heavy in stocks and is sometimes the choice of investors with a high tolerance for risk and a long-time horizon (10 years or more). A hypothetical example allocation might be 70%–90% stocks and 10%–30% bonds.

• Moderate asset allocation. Sometimes called a growth and income objective, this allocation is most suitable for investors who don't mind taking a moderate degree of risk but still want to outpace inflation in the long run. A hypothetical example allocation might be 40%–70% stocks, 30%–50% bonds and 0%–20% cash or equivalents.

• Conservative asset allocation. These are often a good fit for investors with a low tolerance for risk and a short time horizon (fewer than three years). These investors also may be near or in retirement. A hypothetical example allocation might be 0%–30% stocks, 40%–70% bonds and 0%–30% cash or equivalents.

These asset allocations are examples and not recommendations. A financial advisor can help you determine the allocation that best fits your unique goals and risk tolerance.