What’s an Asset Class, and What Does It Have to Do With Diversification?
Investors’ goals are to maximize earnings while minimizing losses. Some investors feel that spreading their money among asset classes is a good hedge against downturns.
Bottom Line Up Front
- Asset classes are groups of securities that share similar characteristics and tend to experience similar fluctuations in the marketplace.
- The 5 core categories most often cited include cash/cash equivalents, equities, bonds, commodities and alternative assets.
- Investing in companies across asset classes can be a good way to minimize the impact of potential losses.
Time to Read
4 minutes
August 19, 2024
Whether you’re a newbie or a seasoned investor, you probably know how important it is to have variety in your portfolio. And, how you choose those investments can make a difference in your outcomes. Some investors believe that if they include investments from each asset class, their portfolio will be well-diversified naturally. And, a well-diversified portfolio will mean that they may do better in the long run. But, just what is an asset class? Let’s take a closer look at them and the role they play in diversification.
What are asset classes?
Asset classes are groups of securities that share similar characteristics and can experience similar fluctuations in the marketplace. They also may be required to adhere to the same legal requirements. But, they each have their own risk and return factors. And, that’s why some investors feel that investing in each class is an easy way to diversify and still earn good returns. The core categories most often cited are:
- cash/cash equivalents
- equities
- bonds
- commodities
- alternative assets
Risk levels can vary among the companies within each class. For example, bonds are rated AAA to D, which reflects their risk level. Likewise, some stocks can be much riskier than others.
Here’s a general breakdown of each.
| Asset Class | Description |
|---|---|
| Cash/cash equivalents | Are liquid, which means they can easily be converted to cash. These tend to be lower risk than other investment types, but also yield comparatively lower returns. Some examples include savings accounts, certificates, money market funds and treasury bills. |
| Equities | Stocks, which are ownership shares in companies, offer potential growth and dividends. |
| Bonds | Investors lend a government or company money, and in turn, they provide regular interest payments and repayment of the principal at maturity. |
| Commodities | Physical goods like oil, precious metals, rice, livestock |
| Alternative assets | May carry more risk than traditional investments. Some examples include real estate, cryptocurrency, art, collectibles and venture capital. |
What does all this have to do with diversification?
First, let’s define diversification. Put simply, it means having a variety of investments in your portfolio. In other words, you spread out your investment dollars among different asset classes, industries and companies to reduce risk and lessen the impact of potential losses. So if, for example, one of your investments or investment classes performs poorly, the gains you earn from others may help offset losses. That, in turn, may help to maintain your portfolio’s overall stability. Risk within each class varies by the specific investments chosen, so it’s important to evaluate each carefully.
Since it’s unlikely that all or most of the securities across all asset classes will experience a downturn at the same time, a number of investors feel asset class diversification can be a good way to protect themselves. Many cash equivalents are backed with guarantees. But, there are no guarantees in the other investment classes. So, investing in multiple asset classes can reduce overall risk.
Keep in mind that what’s happening in the economy will have a huge impact on how the securities in the various asset classes perform. For example, investment grade bonds—while generally safer than stocks—might not be as attractive while inflation is high or when interest rates are increasing. On the other hand, although stocks are traditionally considered riskier, if you wanted to invest in stocks during a volatile market, blue chip companies might work for you. (Blue chip companies are large companies that are industry leaders with a long history of growth and have name recognition.)
A portfolio that includes several asset classes might look like this:
Stocks >> Bonds >> Cash/Cash Equivalents >> Commodities >> Real Estate
As we explained above, what ends up in your portfolio will depend on your preferences, short- and long-term goals, age and risk tolerance. Interested in more ways to diversify your portfolio? Our article How to be Strategic in Diversifying Your Investments explains how being strategic can help you take advantage of high performers and weather downturns. If you’re still uncertain about what to do, consulting with a knowledgeable professional can help.
Smart Money Tip
While diversification can reduce risk, it doesn’t guarantee profits or eliminate the possibility of loss. Proper diversification requires careful consideration of your investment goals, market conditions, risk tolerance and time horizon.
Need Help Deciding?
Navy Federal Investment Services financial advisors are trained specifically to help with just these types of scenarios. They can take a comprehensive look at your overall financial picture to help you build a customized long-term strategy that makes sense for your specific situation. Some of the services they provide include investment guidance, recommendations for an investing strategy and personal portfolio management. And, the first consultation won’t cost you anything. You can find an advisor near you by visiting our financial advisor locator page.
Disclosures
This content is intended to provide general information and shouldn't be considered legal, tax or financial advice. It's always a good idea to consult a tax or financial advisor for specific information on how certain laws apply to your situation and about your individual financial situation.