Asset classes explained
When investing for the future, you'll need to invest in the right balance of asset classes to minimise volatility and help protect your investment from risk.
In this guide, we're going to take a look at what an asset class is, the types of asset class available, and what asset allocation you need to consider for your wealth. Read on to find out more.
What is an asset class?
An asset class is a group of securities or investments that share related characteristics and behave much the same way in the marketplace. Each class is often subject to the same laws or regulated in a similar way, though this may not always be the case.
There is a long-running debate about exactly how many asset classes there are, with many financial experts preferring to use fewer, broader categories, and others more numerous, specific classes. The financial markets are changing all the time — new products pop up and others lose popularity — so it's hard to point to a definitive answer.
What are the five asset classes?
The five asset classes are:
Here, we're going to take a look at what each of the five asset classes are, which investments they include, and the advantages and disadvantages of each one.
|✓ Doesn't pose a capital risk||✗ Susceptible to inflation risk|
|✓ Backed by the government||✗ Provides limited opportunity for growth|
|✓ Assets are easily accessible|
Typical investments: Physical currency, bank accounts, savings accounts, cash ISAs
Risk profile: Low
Cash is the asset class that you're probably most familiar with, as we use it on a daily basis to pay for goods and services. The asset class for cash includes physical currency, the balances of savings and current accounts, cash ISAs, premium bonds, and money market funds.
What are the advantages of cash?
The main advantage of cash as an asset is that it is very safe. It's the only class that doesn't pose capital risk, as you'll always get back what you put in. Cash is also backed by the government: they'll protect a bank account or cash ISA for up to £85,000 through the Financial Services Compensation Scheme (FSCS) should a bank or building society go bust. Another benefit of cash assets is that they are typically liquid and can be accessed quickly and easily at any time (though you can also lock cash away in fixed-term deposit accounts for slightly higher returns).
What are the disadvantages of cash?
The main disadvantage of cash assets is the danger posed by inflation risk. This happens when your savings are not gaining enough interest to beat the rising cost of living. In this scenario, the value of your money would effectively be eroded, even though your capital is not at risk. If you're looking to grow your savings quickly and you have too much invested in cash assets, your wealth won't be going anywhere fast.
|✓ You know exactly how much you'll earn||✗ At risk of issuer default|
|✓ Potential to provide regular income||✗ Lower rate of return than shares|
|✓ Less risky than shares||✗ Susceptible to interest rate risk|
|✓ Good for a diverse portfolio|
Typical investments: Bonds, debentures, gilt-edge bonds
Risk profile: Low
Fixed-interest investments — sometimes known as fixed-rate securities — are an asset class that sees investors loan their money to a company or government in exchange for a security, in the form of a bond or similar product, that pays an agreed rate of interest. This rate remains the same throughout the duration of the investment. When the investment matures, you'll also be paid back the original amount you put in.
What are the advantages of fixed-interest investments?
The key advantage of a fixed-interest investment is that you know exactly how much you stand to earn over its term, which makes for easy financial planning. Provided the organisation that issued the security does not default, you can even work out precisely when and how much you can expect to receive on a certain date. Because they pay out interest at certain intervals, they can be a good choice if you're looking for an investment that provides a guaranteed, regular income.
And, because bondholders are given preference over shareholders if a company goes bust, purchasing a fixed-interest security is less risky than investing in a company’s equity. However, it's worth remembering that bondholders are, in-turn, outranked by creditors, so there's never a complete guarantee that you'll get your money back should an organisation fail.
Fixed-interest securities can also be impacted by market events in a different way to equities. So, if stocks take a hit, it may be the case that the bonds you hold are experiencing stronger returns. This makes them an excellent candidate if you’re looking to build a portfolio of diverse asset classes that has a good balance to it.
What are the disadvantages of fixed-interest investments?
Though they’re fairly low-risk, fixed-interest investments still aren’t a sure bet. Even though they will provide regular interest that is contractually obliged to be paid, if the organisation defaults, your investment is at risk. Bonds are traded on the stock market, and they can lose their value if the company runs into trouble, so you're not guaranteed to get all of your money back.
Plus, fixed-rate investments are subject to interest rate risk. When interest rates go up, they remain static, so they become less valuable. However, the opposite is also true, and they can hold more value if interest rates decrease while you're holding them.
|✓ Good track record of beating inflation||✗ Requires long-term investment|
|✓ Extra stream of income if you buy to let||✗ Funds can get tied up in slow sales|
|✓ Effective way of diversifying portfolio|
Typical investments: Buying your own home or a holiday home, investing in buy-to-let
Risk profile: Medium
Investing in property can take many forms, such as buying your own home or getting involved in commercial property, like offices, warehouses, and retail space. There are opportunities to invest in both small and large-scale projects, ranging from a single buy-to-let to joining an investment fund that owns large-scale commercial sites.
What are the advantages of property?
Property is an asset class that has a track record of beating inflation. It can be a good long-term investment if you're looking to take advantage of an improving housing market, while renting out your buildings can give you another regular stream of income that you could channel into a savings account or invest in other assets.
What are the disadvantages of property?
The main disadvantage of property is that it's a long-term investment that needs time to produce the best returns. Taking on a mortgage or even buying outright is also a major financial commitment and requires a large initial outlay, so it needs to be an investment that you're going to be comfortable with for the next few years. There is also a significant risk of over-concentration i.e. a lack of diversification due to holding only one or two properties in a certain area.
Plus, it's easy to get your money tied up in property, as the market moves slowly, and quick sales are sometimes not possible, so you may be forced to accept a price lower than you paid if you need to liquidate your investment.
|✓ Potential for higher returns||✗ Affected by factors beyond your control|
|✓ Good at beating inflation||✗ Long-term commitment required|
|✓ Possibility of regular dividends paid|
Typical investments: Purchase of equity in a company listed on the stock exchange
Risk profile: Medium to high
When you buy shares — also known as equity — you are buying a small portion of ownership in a company. Each share represents a unit of ownership, so the company value is divided by the number of shares to give the share price. Shares are traded on the stock market, where the daily value of each company's shares are listed.
There are a number of factors, such as if the company does well or undergoes a merger, that can cause the value of a business to increase and boost the worth of each share. On the other hand, if the company does badly, the shareholders can face a drop in the worth of their shares.
What are the advantages of shares?
The main advantage of investing in shares is their potential to deliver better profit than lower-risk assets, such as cash and bonds, making them a good choice if you're looking to beat inflation. Equities can provide better long-term returns, with short-term volatility evening out and having less impact if you invest for ten or more years. In addition, some companies will pay dividends to their shareholders, providing a regular income stream.
What are the disadvantages of shares?
The price of shares is affected by many factors, many of which are beyond the control of the company. When prices rise and fall, it may be the case that your shares are worth less than you paid for them, especially during times of economic uncertainty. However, the market could well go on to recover, and you could find that you're turning a profit once more. To get the best out of any equity investment, you need to be in for the long haul, so if you need your funds to be readily accessible, it's worth considering other asset classes.
|✓ Potential for quick, sizeable gains||✗ Markets are very volatile|
|✓ Effective way to beat inflation||✗ Less liquidity than other assets|
|✗ Affected by factors beyond your control|
Typical investments: Oil, coffee, gold
Risk profile: High
Commodities are raw materials that are bought and sold on global markets where supply and demand, as well as other global issues, dictates the price. They can include fuels like oil and gas; precious metals like platinum, gold and silver; agricultural products like wheat, coffee, and dairy products; industrial metals like copper, iron, and steel; as well as many other things. A lot like shares, commodity markets regularly rise and fall, but they tend to be much more volatile.
What are the advantages of commodities?
While the market prices of commodities fluctuate a lot more than others, a smart investor can make a much bigger income in a short space of time, though this carries higher risk. Adding commodities to your portfolio is also a good way to secure your wealth against inflation. While the likes of stocks and bonds will perform poorly against high inflation, commodities perform well thanks to the increase in price of goods and services.
What are the disadvantages of commodities?
Because the commodity market is incredibly volatile, an investment carries a much higher level of risk than other asset classes. Commodities also offer much less liquidity: it's more difficult to buy and sell your assets quickly without affecting the price. Couple this with the fact that commodities are at the mercy of both nature and geopolitics, and you have a market that can quickly change direction — for better or for worse.
Typical investments: Art and antiques, wine, watches, peer-to-peer lending
Risk profile: Low to high depending on investment
Aside from the main five asset classes, there are other areas that you can invest in to really add diversity to your portfolio, though it's worth remembering that each will have its own levels of risk and reward that you should research.
Although these fall outside of the traditional asset classes, many alternative types have been traded in for a very long time. Art, antiques, stamps, watches, wine, and jewellery are all examples of valuables that have been traded for centuries. On the other hand, there are many new asset classes that have only emerged in the last few years, such as cryptocurrencies and peer-to-peer lending, demonstrating just how diverse the investments marketplace can be.
Many people are of the opinion that newer asset classes are riskier than those that are more established, but this is not always true. For example, peer-to-peer lending is a fairly new type of asset that can have a relatively low risk profile, depending on the types of people or companies you’re lending your money to. Investors lend their money directly to borrowers without the need for a bank, boosting the rate of return. While this means that cover from the Financial Services Compensation Scheme (FSCS) is not provided, the best P2P platforms guard against potential loss with contingency funds and back-up service agreements. Read our guide to safety in peer-to-peer lending for more information.
The result is a good investment opportunity that can offer better and less volatile rates than many ISAs, bonds, and savings accounts, by taking on a little more risk. You can find out more in our guide to the advantages and disadvantages of peer-to-peer lending.
It’s important to remember that with all investments, your capital is at risk.
We hope this guide has given you an insight into what the different asset classes are and which might be right for you. Feel free to contact our team if you have any questions about investing for the future or building your portfolio. You can also find more advice in our help centre.