Investing has a language of its own. Learn what an asset class is, what the four major ones are, and how to pick one or more of them – so you can get your money working hard for you.
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You’ve paid off your high-interest debt. Now you’re ready to put your money to work for you. Ready to start investing. Excellent. Where to begin? Start by learning the major asset classes – or main types of investments – so you know which of them make sense for you.
Generally it’s smart to put several asset classes to work for you, at least over the long term. That’s the best way to make money. It helps even out the inevitable ups and downs of each type of investment.
What are Asset Classes?
Asset classes are groupings of investments with similar characteristics. All four major asset classes can be further broken down into sub-categories based on size, industry, location, and more.
Let’s use wine as an example. White wine, red wine, rosé wine, dessert wine, and sparkling wine are all types of wine. Wine would be the asset class, and each subtype would be a group of similar investments within the asset class.
The four major asset classes are:
- Equities (stocks) – you own a piece of a company.
- Fixed-income investments (debt) – you become a lender to a company or government in exchange for interest.
- Cash and cash equivalents – you have money in bank accounts, in your wallet, or in your mattress.
- Real estate and commodities – you own physical assets such as homes, land, commodities, and precious metals.
As you might expect, each asset class has its pros and cons. And each asset class can be further dissected into smaller parts. Which all have their own pros and cons as well.
Here’s the 30,000-foot view, so you know your options before you start plunking down your hard-earned money.
Asset Class #1: Equities and Stocks
When you buy a stock, you buy a piece of a business. You own a share of the company, which makes you a shareholder.
As an investor in equities/stocks, you can make money two ways:
- Selling the stock at a higher price than you bought it.
- Earning dividends (quarterly payments) on the company’s earnings… payable to shareholders via cash or stock.
Stock market prices can rise and fall for various reasons – overall economic conditions, supply and demand, natural disasters, world events, interest rates, and more.
As an asset class, stocks and equities are sold on three main U.S. indices – the S&P 500, the Dow Jones Industrial Average, and the NASDAQ.
The S&P 500 (Standard & Poor’s 500) Index is a weighted index of the 500 largest publicly traded companies in the U.S.
The Dow Jones Industrial Average (DJIA) reflects the prices of just 30 large companies on the New York Stock Exchange.
The NASDAQ contains about 3,200 publicly traded companies. It’s the second largest stock exchange, and the largest electronic exchange. Many types of companies trade on the NASDAQ – consumer goods, energy, finance, healthcare, utilities, transportation. However, it’s perhaps best-known for innovative tech companies, like Apple and Microsoft.
Many people aim to “beat” one of these indices. But overall, if you invest regularly and track with one of the indices over the course of 40 or 50 years, you’ll do very well. Time is your friend.
You can also buy foreign stocks on various exchanges around the world.
Asset Class #2: Fixed-Income Investments
Fixed income investments refer to any investment where the borrower (the issuer) is required to make interest payments on a regular, fixed schedule. And then return the entire principal amount at maturity (the date the agreement ends).
Bonds are the most common type of fixed-income investment. They can be issued by the federal government, a city, or a company. Basically, it’s a loan you make to the company or government.
Different bonds have different credit ratings and risk, based on the financial strength of the issuer. So-called junk bonds have lower credit ratings, higher interest rates, and higher risk.
Bonds are generally considered very low-risk investments. But they also give relatively low returns. And may not even keep up with inflation. Which makes their biggest risk inflation.
Other fixed-income securities include CDs, money markets, and preferred stock shares.
Asset Class #3: Cash and Cash Equivalents
Cash and cash equivalents include cash in bank accounts. Plus anything else with a stable value that can easily and quickly be converted into cash. In other words, it’s like having cash available. These are your most liquid assets.
Your personal emergency fund should be in cash and cash equivalents. It’s there in case of an emergency. If you have an emergency, you need to be able to put your hands on that cash quickly. The same goes for your down payment fund and anything else you’ll need in the short term.
You know what cash is – your bank accounts, whatever’s in your wallet, etc. Examples of cash equivalents include money market accounts and short-term CDs with maturity dates less than three months in the future.
Cash equivalents should have a known value, not be subject to fluctuations (as stocks are), be highly liquid (you can turn them into cash fast), accessible, and easily bought and sold.
Asset Class #4: Real Estate and Commodities
This asset class consists of physical objects.
Real estate could include rental properties, houses to flip, or vacation homes. Generally, real estate (as an investment) excludes your own personal residence. You treat that differently than you would a true investment.
If you’re deterred by the amount of money you need to get into real estate, or the amount of work involved, consider a Real Estate Investment Trust (REIT). There you become part owner of real estate with others in a similar manner to a mutual fund. You can buy these through your brokerage account. Or privately, without SEC oversight.
A commodity is any valuable raw material or primary agricultural product that’s bought and sold and used as a means of exchange. Things like copper and coffee are commodities.
Precious metals – silver and gold – are a common type of commodity. You can buy physical silver and gold. Or you can invest in precious metals stocks in the stock market.
Other examples of commodities include collectibles or valuable artwork.
This asset class is the least liquid of all. Meaning you can’t easily and quickly turn the asset into cash. Think of it as a long-term holding.
Which Asset Class Is Best to Invest In?
That’s the million-dollar question. The answer is usually all of them. Don’t put all your eggs in one basket. Diversification protects you.
Financial advisors most often advocate a mix of stocks and bonds.
Stocks are variable-income securities. Returns vary based on market cycles, the soundness of the underlying business, and other factors. With bonds and other fixed-income securities, you know your returns in advance. They’re fixed.
However, stocks are the logical first step if your employer offers a 401(k) with a company match. You’re already doubling your money by contributing enough for them to match. You’d be crazy to overlook that.
Bonds do well in a high-interest rate environment. But high interest rates aren’t generally good for stocks because they’re not good for business. High interest rates mean high borrowing costs for companies and consumers…
Many precious metals investors consider gold and silver the ultimate hedge. Sometimes, but not always, precious metals trend higher when the stock market goes down.
Some people hate the work involved with real estate. Who wants a call at 3 a.m. about a clogged toilet? There are ways around that (management companies). But it’s something to evaluate before jumping into this asset class. On the flip side, plenty of people have become millionaires by investing in real estate.
Cash and cash equivalents have their place too. But they won’t make you rich on their own because their returns are too low. Use them for shorter-term goals or things you’ll need money for soon.
These are considered the major asset classes. There are others. Cryptocurrency, for example.
All this means that you need to understand the pros and cons, decide your own priorities, and invest accordingly. Only you know your own situation. There is no perfect asset class or investment. But if you linger too long in indecision you’ll lose valuable time in asset growth.
The truth is that there are many successful investors across all asset classes. Diversification is key to protecting your returns. Start with one asset class. Learn everything you can about it.
Then as you’re able, expand into other asset classes to create a well-rounded investment portfolio.