Investment Basics: Asset Classes and Investment Structures
- InvestmentsThis month, I’m continuing with the theme of investment basics. Now that I’ve summarized some of the basic terms, I want to cover the most common types of assets (aka asset classes) and investment structures you might invest or save in.
To clarify, an asset class is a way to categorize investments which function similarly and are covered by the same rules and laws. An investment structure is just a way to own those asset classes.
Let’s start with asset classes. The point of understanding the different asset classes is that they can help you decide what you want to hold in your investment portfolio. In general, each asset class has a low correlation with the others when it comes to performance. If your goal is to reduce volatility / price fluctuations in your portfolio, you might decide to invest in a broad range of asset classes because when one is down, some others will typically be up. If you don’t mind the volatility, you might settle on one or two asset classes with higher potential returns. Or you might have other goals which lead you to choose other asset classes.
Here is a list of some of the most commonly held asset classes:
1. Cash and Cash Equivalents: This is the class of assets which is most liquid, meaning it’s readily available or easily convertible for spending. Cash is just money in coins or bills (including money held virtually); it lives in your checking and savings accounts. Cash equivalents behave like cash and are easily convertible for spending; examples include guaranteed investment certificates (GICs), the U.S. government’s Treasury Bills (T-Bills), and money market accounts. Since the value of cash and cash equivalents doesn’t fluctuate much, you’ll earn a relatively low rate of return on these assets.
2. Fixed Income: With this asset class, you loan your money to someone else for a fixed amount of time in return for fixed interest payments. Bonds and CDs are examples of fixed income investments. With a CD, you agree to deposit your money for a fixed amount of time, like two or three years, in exchange for fixed interest payments which are a bit higher than the going rate for savings accounts. You’ll pay a penalty if you take your money out before the end of the agreed-upon period.
Bonds are fundamentally loans you make to a company or government. Examples include the U.S. government’s Treasury notes and Treasury Inflation-Protected Securities (TIPS), municipal bonds, and corporate bonds. The higher the risk of nonpayment of the loan, the higher the interest rate the borrower has to pay. In general, though, the value of fixed income instruments remains fairly stable, so they also tend to have lower rates of return.
3. Real Estate: This asset class involves owning a building or piece of land. You might own your own home and make a profit when you sell it, or you could do the same with a plot of land. Alternatively, you might own a home, a piece of commercial real estate, or a piece of land for the purposes of renting it to someone else. You might also decide to buy homes and fix them up for resale. Typically, real estate prices are more volatile than those for bonds, but not as volatile as those for stocks, so you’ll earn returns somewhere in between the two.
4. Equities / Stocks: Stocks are all about owning a piece of a company. You can make money from this investment via the cash dividends a company pays to its shareholders, or by selling your piece of the company for more than you paid for it. The value of stocks can vary widely, depending on which types of stock you own, and your acceptance of this volatility comes with higher average returns over the long term.
5. Commodities: These are raw products which can be turned into other products or services, and they include things like agricultural staples, metals, and energy resources. As the name “commodity” implies, there’s not usually much difference between one commodity and another. For example, the pork bellies you get from one megafarm are pretty much the same as the pork bellies you get from another megafarm. Over the long term, the return on commodities tends to be fairly low and prices are quite volatile; investors use them to protect themselves from rapidly-increasing inflation.
6. Other: The list of asset classes above isn’t exhaustive. If you own copyrights or patents, for example, they might produce income over time, and you can also sell them to others like you would anything else. You also have personal property which might be considered assets, such as vehicles, art, collectibles, jewelry, and so forth. Just be careful about including these in your investment portfolio because it’s hard to be sure any one item will increase in value at a rate higher than inflation, and that's the goal when you're investing. These assets might also be more difficult to liquidate and turn into cash when you need to.
You can own assets in a variety of ways, or in different investment structures. For example, you might own a home or an individual stock in one company. But you might also buy assets in one of the structures below, which can deliver efficient diversification and access to investments small, independent investors usually don’t get a chance to own.
1. Mutual Fund: A mutual fund is a pool of money from individual investors which is used to buy a bundle of assets like stocks, bonds, real estate, etc. The mutual fund owns the underlying assets, and the individual investors own shares of the mutual fund. Investors buy and sell shares of the mutual fund from the fund itself, not on an exchange. Mutual funds are usually set up around a common theme, such as market indices (like the S&P 500), asset classes like small-company stocks or short-term bonds, market sectors like pharmaceuticals or construction, or even ethical considerations like minimizing environmental impact or supporting women’s representation in leadership.
Professional investment managers build the fund’s portfolio and take care of its ongoing operations, which reduces the load on the individual investor. Mutual funds also make it easy to buy a range of investments when you might not have enough money to buy each one individually. They are an efficient way to diversify your holdings because you can just buy shares of a mutual fund instead of buying the hundreds of assets it comprises. These advantages come with a cost in terms of fees, so make sure you know how much your funds are charging you for all that efficiency and diversification.
2. Index Fund: This is a specific type of mutual fund whose purpose is to mimic the performance of a market index or benchmark, such as the S&P 500, the Nasdaq Composite, or the entire U.S. bond market. These funds don’t need a professional manager because they are just built from the individual assets in that particular index; for example, an S&P 500 index fund is made up of stocks from the companies in that index. This means these funds have lower fees, since they are run by algorithms instead of a team of highly paid investment advisors. As with mutual funds, you buy and sell shares from the index fund itself, not from an exchange.
3. Exchange-Traded Fund (ETF): ETFs, like index funds, are set up to mimic the performance of a market index or benchmark. They provide easy, efficient diversification. But unlike index funds, they are traded on a stock exchange, rather than bought and sold through a mutual fund company. The fees are low, as with index funds, but they don’t have a minimum investment amount like many mutual funds, and they can be more tax-efficient.
4. Real Estate Investment Trust (REIT): REITs are like mutual funds, but they pool the money from individual investors to buy real estate assets. Unlike mutual funds (but like ETFs), they are traded like stocks, on an exchange (although some REITS are private). REITs come in a variety of flavors based on the types of real estate they buy: there are REITs for residential rental properties, golf courses and amusement parks, nursing homes, malls and retail stores, office buildings, and many more.
5. Hedge Fund: As the name implies, the purpose of a hedge fund is to protect investors from market instability, so returns will (hopefully) continue to flow regardless of what’s happening in the investment markets. Hedge funds are private investment partnerships which trade mostly in liquid assets. They are similar to mutual funds in that they pool money from investors to build a shared portfolio. But these portfolios often use complex, alternative investment strategies like borrowing, short-selling, and derivatives, which I won’t go into here. To invest in a hedge fund, you have to be an accredited or institutional investor, which means you have to meet criteria which identify you as more “experienced." If this all sounds really fancy, you’ll have an idea of the fees and risks involved.
6. Venture Capital (VC) Fund: VC funds are managed by a venture capital firm, and like hedge funds, their investors are typically accredited (“experienced”) individuals or institutions. A venture capital fund invests in startup companies, which by their nature are riskier investments but offer a higher potential return. And yes, investors will be charged for the privilege of working with a VC fund: usually a management fee plus a percentage of any profits.
7. Crowdfund: Crowdfunding is like a VC fund for the other 99%. Crowdfunding tends to happen in a decentralized way, via a website like Kickstarter or Indiegogo, where even the tiniest of projects or ventures can ask for funding directly from individual investors. Sometimes crowdfunding is used to donate money to a project or venture, but for our purposes I’m talking about crowdfunding which promises you a slice of the profits. As you can imagine, the risk varies widely depending on the project and how much you contribute.
To wrap up, I’ll mention Alternative investments. “Alternative” isn’t really an asset class or an investment structure; it’s more of a category made up of items from both of them. As the name suggests, these are investment options which are just a bit unconventional. They might have different regulatory requirements from your basic cash, bonds, and stocks, or they might have none at all. Here are some examples of Alternative investments:
1. Art, antiques, and collectibles
2. Commodities (sometimes)
3. Crowdfunding
4. Cryptocurrencies
5. Derivatives
6. Hedge Funds
7. Managed Futures
8. Private Equity
9. REIT
10. Venture Capital
Because Alternatives aren’t regulated in the same way as conventional investments, you’ll want to do your research before you invest in them, to prevent being scammed or defrauded, but also to be sure you thoroughly understand the costs and potential risks.
I hope this issue has helped you feel a bit more grounded in your investment options, and please stay tuned for more investing basics next time.
