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Education

Get to Know Various Types of Asset Classes

Portfolio construction is key to achieving investment goals. Understanding the general principles of how asset classes work together can provide investors with the foundation for constructing well-diversified portfolios.

What you will learn

  • Major traditional and alternative asset classes
  • The role of alternatives in a portfolio
  • How diversification works across asset classes and investments

What are traditional asset classes?

The major asset classes include bonds, cash and stocks. Bonds and cash have traditionally been viewed as defensive asset classes that many investors use to provide a source of regular income.

Stocks, alternative investments and property, on the other hand, are considered growth assets that aim to boost long-term capital appreciation.

Each asset has its own risk/reward profile. While cash is considered to carry the least risk, it also has the lowest return potential. Conversely, equities and alternatives may carry greater risk but also offer higher return potential.

In uncertain markets, investors may hold larger than usual amounts of cash in an attempt to reduce their risk exposure. It may be possible, however, to prudently take on more risk and incrementally step-up return potential while still managing volatility.

The Relationship Between Risk and Reward
A diagram shows five assets positioned on a graph of reward potential versus risk. The Y-axis represents reward, while the X-axis shows risk. The asset classes staircase upwards along the graph in terms of reward and risk. A box labeled “Cash” is positioned in the bottom left-hand corner of the graph, with the lowest reward and risk of the asset classes shown. Short-term bonds are next, situated to the right and higher up. The staircase continues, in order of greater potential reward and risk: core bonds are in the middle of the graph, followed higher up and further to the right by high yield bonds. In the upper right-hand corner, equities have the highest potential reward and risk. Each asset contains some further bulleted points on their characteristics.
For Illustrative Purposes Only

What are alternative asset classes?

There is no single definition of what constitutes an alternative asset class and so the term covers a broad range of investments. Generally, alternative investments encompass those outside the mainstream classes of stocks, cash, and bonds.

Examples of alternative investments include commodities, private equity, infrastructure, real estate, and hedge funds.  Previously designed for institutional investors, alternative investments are now available to individual investors through alternative investment funds.

Alternative assets are generally included in a portfolio for two key reasons:

  1. Diversification: They represent a different source of risk and return for a portfolio.
  2. Inflation hedge: Inflation can have a big impact on return. Rounding out a core portfolio with non-traditional and inflation-hedging assets can help investors pursue opportunities across economic environments.

For example, in higher inflationary environments, assets such as real estate and commodities may perform better (as illustrated in the chart below).

The diagram shows a collection seven asset classes, represented by shaded circles, positioned on a graph of four quadrants. The Y-axis represents growth, while the X-axis shows inflation. A circle representing cash is in the center, with all of the other asset classes surrounding it. Three of those circles represent traditional asset classes, and are shaded in blue. Traditional bonds are positioned in the bottom left-hand quadrant, meaning they may perform better in an environment of low inflation without growth. Traditional stocks are in the upper left-hand quadrant, better in an environment of low inflation with growth. The chart also shows four other asset classes, shaded in gray, that are part of a broader asset allocation. The asset class of high yield bonds straddles the northwest and southwest quadrants, indicating better performance in an environment of low inflation and low positive or negative growth. On the right side, three other asset classes round out the broader allocation. Emerging market securities are in the northeast quadrant, for high inflation and growth. Commodities and real estate straddle the X-axis, for high inflation and low positive or negative growth. Positioned in the southeast quadrant, Treasury inflation-protected securities might perform best in high inflation environments without growth.
For Illustrative Purposes Only

What’s the role of diversification?

A well-diversified portfolio is split across asset classes as well as among investments within each asset class. Maintaining a diversified portfolio can help investors prepare for shifts in the economy and interest rates, providing the potential to not only capture opportunities but also minimize risks associated with overconcentration in one asset class.

Diversification within equities can be achieved by investing in stocks from different sectors, countries, and companies. Diversification in bonds can be similarly achieved by investing in different sectors, countries, issuers, and bond types.

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