A beginner’s guide to asset classes

Understanding the Investment Risk Ladder

Below are the main types of investments ranked from lowest to highest risk on the investment ladder.

Cash

A cash bank deposit is a straightforward and safe investment option. It’s easy to understand and offers a guaranteed return on interest, ensuring investors get their initial investment back.

However, the interest earned from cash in a savings account usually doesn’t keep up with inflation. Certificates of deposit (CDs) offer higher interest rates than savings accounts. Still, they’re less flexible because the money is tied up for a set period (months to years), and withdrawing early may result in penalties.

Bonds

A bond is like an investor’s loan to a borrower, company, or government agency. The borrower promises to repay the loan with a fixed interest over time. Organizations often use bonds to fund activities like running a business or buying needed things.

Bond rates depend on interest rates, so they’re often traded when interest rates change. This happens especially when the Federal Reserve or other central banks increase or decrease interest rates.

Mutual Funds

A mutual fund is like a group investment where many people combine their money to buy different investments like stocks and bonds. It’s not a set-and-forget type of deal because there are managers who decide where to put the money in these investments. You usually need to invest at least $500 to $5,000, but some funds don’t have a minimum requirement. Even with a small amount of money, you can be part of a fund that owns up to 100 stocks.

Mutual funds are priced at the end of each trading day, and all buying and selling happens after the market closes.

Exchange-traded funds (ETFs)

Exchange-traded funds (ETFs) have become very popular since they were introduced in the mid-1990s. They’re like mutual funds but trade on a stock exchange all day. This means their value can change significantly during the day, like stocks.

ETFs can follow an index like the S&P 500 or a group of stocks chosen by the ETF provider to represent a specific ETF. This could be anything from emerging markets to commodities or specific sectors like biotech or agriculture. ETFs are very popular among investors because they’re easy to trade and cover many investments.

Stocks

Stock shares allow investors to benefit from a company’s success through rising stock prices and dividends. If the company goes bankrupt and needs to sell its assets, shareholders have a claim to a portion of those assets, but they don’t own the assets themselves.

People who own common stock can vote at shareholders’ meetings. People who own preferred stock can’t vote but get priority over common shareholders when paid dividends.

Alternative Investments

There are many different types of alternative investments, which include the following sectors:

• Real estate: Investors can buy real estate by purchasing commercial or residential properties. Another option is to buy shares in real estate investment trusts (REITs). REITs work like mutual funds, where many investors combine their money to buy properties. They trade on the stock exchange, just like stocks.
• Hedge funds: Hedge funds invest in various assets to make higher returns than the market, called “alpha.” But their performance isn’t sure, and sometimes they don’t do well, even by a lot. Usually, only rich investors can invest in hedge funds, and they need to invest a lot of money, often $1 million or more. Investors also need to have a certain amount of money to invest. Hedge fund investments might lock up an investor’s money for a long time.
• Private equity fund: Private equity funds work like mutual and hedge funds. A private equity firm, acting as the “adviser,” collects money from many investors and uses it to invest. These funds often buy a big part of a company and work to make it worth more. Some private equity funds aim at growing companies or startups. Like hedge funds, private equity firms usually look at long-term investments, typically lasting ten years or more.
• Commodities: Commodities are physical things like gold, silver, oil, and farm products. You can invest in commodities in different ways. One way is through a commodity pool or “managed futures fund,” where many investors pool their money to trade in futures and commodities markets. This helps limit each investor’s risk to the amount they contributed. There are also special ETFs made just for investing in commodities.

How to Invest Sensibly, Suitably, and Simply

Experienced investors spread their money across different types of assets to manage risk. A smart tip for investors is to begin with basic investments and gradually add more. Start with mutual funds or ETFs, then consider adding individual stocks, real estate, and other options later.

Many people don’t have time to check their investments every day, so choosing index funds that follow the overall market is a good idea. Steven Goldberg, who works at Tweddell Goldberg Wealth Management and writes about mutual funds for Kiplinger.com, suggests that most people only need three index funds: one for U.S. stocks, another for international stocks, and a third for bonds.

Those who like to be more involved might prefer to pick their mix of assets to create a diverse portfolio that matches their risk tolerance, how long they plan to invest, and what they want to achieve financially. This means you can adjust your investments to focus more on certain types of assets depending on how the economy is doing to potentially earn higher returns.

Asset Class Expectations Given the Economic Environment

First, let’s look at how stocks and bonds have performed compared to each other over time. They tend to move in opposite directions, which means when one goes up, the other usually goes down, and vice versa.

• When the economy is doing well and more people are working, stocks usually do well because consumers are spending and companies are making more money. But at the same time, bonds might not do as well because interest rates go up to match the economic growth, and prices go up. When prices increase a lot, bonds with fixed rates might not do as well if the interest rate is lower than the inflation rate.

As discussed earlier, many financial experts suggest combining stocks and bonds in your portfolio. Some other types of investments might also do well in certain economic situations. However, not all types of investments are right for everyone.

• Real estate: The housing market usually does well when the economy is doing well, and few people are out of work. This can be good for real estate investments. However, if interest rates go up, it can make it harder for people to borrow money for mortgages, which might not be so good for real estate.

• Commodities: When prices increase, certain commodities might also become more expensive. This makes them a good choice for protecting against inflation.

• Alternative investments: Private equity, venture capital, and hedge funds might do better when interest rates are low, and a lot of money is available. But these kinds of investments aren’t always open to regular people, and they might need a lot of money to start. Plus, they might not be easy to turn into cash quickly.

• Gold: People see gold as a safe place to put their money, especially when things are uncertain economically or politically or when prices are increasing significantly. This was true during the COVID-19 pandemic when gold prices increased significantly, reaching their highest in spring 2020.

• Cash and cash equivalents (like money market funds and CDs): These are also safe places to keep money, especially when the economy is uncertain or things are changing a lot. People might choose cash to keep their money safe and avoid losing money when the stock market is down. But when things are stable, and prices aren’t increasing much, cash doesn’t usually make as much money as stocks or bonds. Still, because it’s stable and low-risk, having some cash is a good idea if you want to keep your money safe or need it quickly.

FAQs

The Bottom Line

Learning about investing is important, and it’s crucial to stay away from investments you don’t grasp fully. Listen to advice from seasoned investors you trust, and ignore tips from unreliable sources. When seeking help, choose independent financial advisors who are paid for their time, not those who earn commissions. Most importantly, spread your investments across different types of assets to reduce risk.

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