- What is an asset or an investment asset?
- What is an asset class?
- What are the different types of investment asset classes?
- How asset classifications help
- Why is asset allocation important?
- How to calculate asset allocation
- What is asset diversification in investing?
- Asset allocation vs. asset diversification
- Asset diversification strategies
- Asset classes, allocation and diversification: FAQs
What is an asset or an investment asset?
Have you ever wondered why advisors and investment professionals actively seek out investments that zig when markets zag? At first glance, it seems counterintuitive to own securities that might drag down your overall performance, but the reason is surprisingly simple: Different types of investments will grow at different paces, and few may stumble at the same time. This is why owning a mix of assets can offer investors a way to help smooth out the overall performance of their portfolios.
What is an asset class?
An asset class is a shorthand term used to refer to a group of investments that tend to behave a similar way on the market because they have similar characteristics and are subject to the same laws and regulations. Stocks and bonds are two examples of different asset classes that tend to react differently to certain economic conditions or market environments.
By owning investments that historically behave differently at different points in the economic cycle, investors can cushion the blow of potential losses to help improve the overall health of their portfolios. This is what’s known as diversification — a strategy first developed by Harry Markowitz, the founder of Modern Portfolio Theory, in the 1950s. Essentially, he found that balancing high-risk, high-reward investments with lower-risk, lower-reward investments can allow investors to achieve strong returns with lower volatility.
If creating a diversified portfolio requires balancing your investments to suit your risk tolerance and reward expectations, then understanding the different types of asset classes you can invest in is essential.
What are the different types of investment asset classes?
There are several different types of assets you can invest in, each with their own distinct characteristics and market response. Within each asset class, you’ll have even more options to consider. Let’s start with the traditional asset classes:
An equity investment, also commonly referred to as a stock, gives you an ownership stake in a company. Each stock gives the holder the ability to participate in the growth of a company and claim a share of its profits. Every share represents the amount of money you would get if a company liquidated its assets, less any debt the company owes. Equities can be highly volatile, but may offer higher returns than other asset classes.
Fixed income is a broad category that captures several types of investments, including bonds, treasury bills and Guaranteed Investment Certificates (GICs). Fixed income investments are interest-earning assets that pay a pre-determined rate when held to maturity — often six months to five years, depending on the asset — although the various investments in this asset class have their own distinct characteristics. These investments may provide a more predictable rate of return.
Cash or marketable securities
While the concept of cold hard cash has evolved from coins and paper to the ones and zeros of digital transactions, its function remains the same. Cash is the most liquid asset class because it can be used directly to purchase products or goods. Marketable securities are short-term investments that can be quickly converted into cash. Because these assets can be bought and sold quickly on public exchanges, these investments tend to be lower risk and offer a lower rate of return.
You can think of commodities as the building blocks that make up the things we consume — from the food we eat and the goods in our homes to the oil that ultimately powers our cars. Commodities also include precious metals such as gold, which is used in jewelry and as a store of value, and silver, which is often used in electronics. This asset class may help to offset the effects of inflation, but commodities can also be more volatile at times because of their speculative nature, meaning they are bought and sold based on expectations around future demand.
Many do-it-yourself investors tend to focus on the traditional asset classes, but there are also alternative asset classes available that can help you achieve your financial goals.
If you’ve ever tried to buy a home or rented property, then you understand the value of real estate. The more people who are competing for space, the higher the price. As an asset class, real estate refers to things like vacant land, commercial and industrial properties and, of course, residential homes. Under the right conditions, it can help provide a steady source of income, but it’s considered less liquid than other assets and can be influenced by local factors that are hard to control.
A derivative is a type of contract between two parties. Its value comes from the underlying asset, group of assets or benchmark that the contract is linked to. While the prices of derivatives are tied to their underlying assets, they often involve leverage, meaning money is borrowed to invest. Because the contracts can expire over time, they carry their own risk. The most common derivatives are futures contracts, options and swaps.
Related: The curious investor: How to research stocks and think like an analyst
How asset classifications help
Since different asset classes tend to behave differently depending on what’s happening in the broader economy, grouping them together can help provide a way for investors to figure out the optimal mix for their portfolios. For example, investors who have a higher risk tolerance or a longer time horizon may consider including a greater percentage of equities in their portfolio to capture potentially higher returns. Investors with short-term goals might be willing to pass up higher returns in favour of lower-risk investments that are less likely to experience a significant pullback.
Factors in classifying assets
Assets can be classified in a number of ways. Understanding how assets are grouped will help you determine how they can fit into your portfolio. The three main factors used to classify assets are:
- Convertibility: This refers to how easy it is to convert an asset to cash. Most large-cap stocks can be sold quickly on the market, but with assets like a house or a piece of art, it can take longer to find a buyer and complete a sale.
- Usage: Assets are also categorized by their purpose. Some assets are vital for the daily operation of a business, such as a delivery truck or a computer, while other assets provide value in other ways, such as interest income or a vacant piece of land.
- Physical existence: Tangible items, like machinery, a building or a warehouse are common assets that can be bought or sold, but an asset doesn’t have to be something you can hold to have value. Intangible assets like a major corporate brand or a patent can be equally as valuable to a business or investor.
What is asset allocation in investing?
In investing, asset allocation is a strategy that looks to build a diversified investment portfolio around different asset classes. By adjusting how much of each asset class you own, you can manage your risk and return profile to suit your comfort level, goals and timeframe.
Related: Bulls vs. bears: Why divergent market views may suggest more volatility ahead
Why is asset allocation important?
Markets are in a constant state of flux. The conditions that allow one asset category to excel may cause another asset category to underperform with either below-average returns or, in some cases, a loss. Asset allocation refers to the way you weigh each of these asset classes within your portfolio. For example, someone nearing retirement may choose to adopt a more conservative portfolio with 60% bonds and 40% equities, whereas a younger investor with a longer time horizon may choose to hold a portfolio more heavily weighted toward equities, with less exposure to the other asset classes.
Over time, your asset allocation will naturally float with the change in the value of your investments. It can be important to review your asset allocation periodically to make sure it is still aligned with your financial objectives and risk tolerance. By rebalancing your asset allocation, you may also be able to help lock in your gains and potentially grow your positions in underperforming assets, contributing to your performance as market conditions change. There are different ways to achieve this:
Dynamic global asset allocation
While some investors will set their asset allocation and stick to it, others take a different approach. Dynamic global asset allocation refers to the practice of adjusting the mix of assets based on market conditions to capitalize on opportunities that favour a particular asset class, sector or geographic region.
Asset allocation fund
If you don’t have the time or confidence to manage your own asset allocation, you can turn to an asset allocation fund to take care of this for you. Professional investment managers will regularly manage the amount of fixed income and equities in the fund to ensure the asset allocation is aligned with your risk profile.
How to calculate asset allocation
Like your fingerprint, your asset allocation can be specific to you and your financial circumstances. Asset allocation is a diversification strategy: If you have a longer time horizon and don’t need the money right away, you may choose to invest in more equities because they have historically offered strong returns over time. If you have a near-term goal like buying a house, you may choose to adopt a more conservative asset allocation with limited exposure to equities. If you’re saving for retirement, TD’s Retirement Planner calculator may be another resource to help you determine what asset allocation might be right for you.
What is asset diversification in investing?
To understand asset diversification, think of an NHL hockey team: While every team in the league is made up of highly skilled players, no two teams are exactly alike. Some teams will excel while others will struggle to find their way. A portfolio of assets can behave in a similar manner. Owning a mix of companies within a specific asset category or asset class — such as mining or tech stocks — may help you manage your risk and can boost your returns over time.
Asset allocation vs. asset diversification
To build a diversified portfolio, you need thoughtful asset allocation and careful asset diversification. Asset allocation only refers to the overall mix of asset classes within your portfolio. Within each of the asset blocks in your portfolio, it’s also important to diversify your holdings. Asset diversification is about ensuring the equities you own have a broad representation of different sectors and industries to help minimize the volatility within that portion of your portfolio.
Asset diversification strategies
There are any number of ways to diversify your portfolio. Generally, investors start by determining what asset allocation is appropriate for their needs before figuring out the asset mix within each block. For the equity portion of the portfolio, investors may want to consider looking at different industries and sectors, the market capitalization of companies, risk profiles and, depending on your viewpoint, whether you agree with the company’s environmental, social and governance policies. For the fixed income portion of your portfolio, you may consider things like maturity lengths, sectors and geographic location.
Diversifiable vs. non-diversifiable risk
Diversification can help minimize some risk in a portfolio, but it won’t eliminate it entirely. Non-diversifiable risks include things like business risk, financial risk, operational risk and regulatory risk.
Asset diversification benefits
- Can help lower risk in a portfolio
- Can help smooth out performance
- Potential for stronger returns over time
- Can help manage stress for investors
Asset diversification limits
- Investors may not capitalize on large short-term wins
- Can require constant vigilance and may be best suited for investors comfortable with investing
- May result in more transactions, which could incur fees and commissions
- Can be overwhelming, particularly for novice investors
Frequently asked questions about asset classes, allocation and diversification
What are the five main asset classes?
The main asset classes investors focus on are:
- Fixed income investments
- Cash and cash equivalents
- Real estate
Is crypto an asset class?
Yes. Cryptocurrencies are a new and emerging asset class.
Is an ETF an asset class?
No. An Exchange-Traded Fund, or ETF, is a type of investment vehicle that allows you to invest in different asset classes. ETFs can hold stocks, fixed income investments or commodities — some may even hold a mix of those assets all at once.
What is an example of asset allocation?
A portfolio consisting of 60% equities and 40% fixed income investments is a common example of asset allocation.
How does asset allocation enable you to accomplish diversification?
Asset allocation is the first step in diversification. It works by grouping assets that generally respond to the broader market conditions in a similar way.
What are the risks of having a concentrated portfolio?
A concentrated portfolio can increase your risk that returns will be heavily influenced by the performance of one holding, which then increases volatility and the potential for larger losses.
What is the danger of over-diversification?
Just as a concentrated portfolio can increase your risk, over-diversification can water down your overall performance. It’s important to find the right asset allocation and asset diversification to meet your needs.
Does asset allocation and diversification work?
Yes. Asset allocation and diversification have a long history of helping to reduce portfolio volatility and boost returns over time.