Investment Basics: Everything You Need to Know About Asset Classes

April 24, 2015

An asset class is the category under which a certain type of investment falls based on its characteristics. Within the investment universe, there are many different types of asset classes that can be used to build a well-rounded portfolio. On the most general level, the two major classes are equity, which is made up of stocks, and fixed income, which is made up of bonds. Sometimes managers will also include additional categories such as cash, alternative investments, and allocation investments, which are usually a blend of equity and fixed income.

 

Equity

 

The defining characteristic of equity is ownership. An equity holder is someone who owns a piece of whatever they have an equity holding in. Stockholders are often referred to as shareholders because they “hold,” or own, a share of the company. The equity category can be further broken up based on region, sector, size, and type of growth.

 

In regards to region, stocks are usually broken up into domestic and foreign, which is then further broken down into developed markets (mostly Europe and Japan) and emerging markets (most of Asia, South America, and parts of the Middle East). When investors refer to the term BRIC they are referring to the major countries in the emerging market space: Brazil, Russia, India, and China.

 

As it pertains to sectors, equities can also be broken down into the industries they are a part of. The most common industries are healthcare, financials, technology, defense, utilities, transportation, and consumer goods (things like food and clothing). When you read about a fund investing heavily in healthcare, that tells you that they are investing in hospitals and pharmaceuticals. When a fund is focused on financials, you might see names like Goldman Sachs, JP Morgan and Bank of America in their holdings.

 

The third most common breakdown in equities has to do with the size of a company and what type of growth it experiences. Usually, stocks are broken up into three sizes: large cap, mid cap, and small cap. The term “cap” is an abbreviation for “capitalization” and refers to the market capitalization or total dollar value of a company. You can determine a company’s market cap by multiplying its stock price by the number of stocks it has outstanding in the market. A large-cap company usually has a market cap greater than $10 billion (think Apple or Ford). A mid-cap company is one that has a market cap greater than $2 billion and less than $10 billion, (think Dollar Tree) whereas a small-cap company has a market cap of less than $2 billion (these are usually lesser known companies). Within the size category, companies can then be further broken down into the type of growth they experience depending on whether they are a growth company (think tech companies), a value company (such as Coke or Ford which have been around for a long time) or a blend of the two.

 

Outside of these categories, you will sometimes find oddball categories such as Real Estate and Commodities (things like corn, oil, or gold) that also fall under the equity heading.

 

Fixed Income

 

What is often surprising for most people is the discovery that the fixed income universe is significantly larger than the equity universe. What differentiates fixed income from equity also has to do with the difference between owning and lending. While an equity holder is a part owner of the company they hold, a bondholder is a lender to the company that has issued them a bond. Similar to when you receive a loan at the bank, when you purchase a bond you are making a loan to a company in return for interest in the form of payments or income. At the end of the loan, the company then returns your original investment, what’s referred to as “principal.” Unlike the equity universe, which is fairly uniform, the bond universe is incredibly diverse because bond contracts can be written in a variety of ways. Like equities, bonds can be classified by region, foreign and domestic, but they are also often classified based on their ratings and how long they take to mature.

 

A bond rating is a representation of how risky the bond is: the higher the rating, the safer the bond. Different agencies use different formats of ratings, but they are usually denoted using combinations of letters (A, AA, AAA, B, BB, BBB, etc). Bonds are usually split into two groups based on their ratings: investment grade, and junk. Investment grade means the bond has a triple B rating or higher and is generally believed to be pretty safe. The highest rating goes to government bonds, which are the closest thing we can get to something that is risk-free. Junk bonds are usually bonds issued by smaller, riskier companies. At this point you’re probably asking, why would anyone want junk? The answer is that the lower the rating, the higher the company must pay a lender to borrow money so while a junk bond can be very risky, it can also be very rewarding in terms of the interest received by the bondholder.

 

Sometimes bonds will also be categorized based on how long they’re held before they mature. Bond contracts can be written with varying dates similar to loans: you can get a short-term loan (like a 5-year car loan), medium-loan (like a 15-year mortgage), and a long-term loan (like a 30-year mortgage). Bonds can be similarly classified into short-term, intermediate-term, and long-term. In general, the longer the term, the riskier the bond and the higher the required return. This is because a lot can happen in 15 years and so investors have to be compensated for the uncertainty.

 

While there are many other forms of assets, equity and fixed income are the most common and the categories you are likely to recognize in your portfolio. A good asset manager is one who understands not only how the different asset classes work individually, but also how they come together to complement each other based on their different characteristics.

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