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Pass the asset class

Lesson in Course: Investing basics (beginner, 4min)

There are many different types of investments. What are they and what do we need to know about them?

Eureka!

What it's about: We can organize investments into 5 major categories; Cash, Equities, Fixed Income, Alternatives, Derivatives.

Why it's important: Understanding the nature of these major asset classes gives us a sense of which ones best fit our risk tolerance and investment goals.

Key takeaway: Investing across all of the different asset classes lowers our overall risk from diversification.

While there are countless investments to choose from, we can group them into 5 main categories or asset classes: Cash, Fixed-income, Equities, Alternatives, Derivatives.

What is Asset class?

A group of investments with similar characteristics, often having comparable risks and returns. They are usually traded in the same markets and follow the same rules and regulations.

Let's walk through each, in order of least to most risky, and look at some examples.

Cash

Sometimes referred to as cash and cash equivalents, this asset class is the most familiar. 

Cash is the most liquid

We know it as the paper bills in our pockets and coins in our piggy banks.

There are many other types of cash investments

Examples:

  • Checking and savings accounts
  • Money market accounts
  • Money market funds
  • Certificates of deposit (CDs)

The advantage of cash is its liquidity, meaning we can quickly access it at any time. However, it offers the lowest risk and lowest returns.

Fixed-income

The investments in this asset class are usually bonds, so most of the return is from interest payments. 

Government and businesses borrow money by issuing bonds

Bonds typically have set, or fixed, interest rates which make returns somewhat stable and predictable. Although, there are a few types of bonds where the interest rate changes over time. Owning a bond means we are entitled to the money from interest and principal payments.

Different bonds

Here are a few types of bonds we might encounter:

  • Treasury bonds
  • Municipal bonds
  • Corporate bonds
  • High-yield bonds (aka Junk bonds)
  • Treasury inflation-protected securities (TIPS)

Bond values are more sensitive to some factors, such as changes in the inflation rate or the interest rates set by the Federal Reserve (US central bank). The interest rates we receive from bonds provide a higher return than cash. Fixed-income investments tend to be safer than equities because they would get paid back first if a company goes bankrupt.

Equity

Equities are usually referred to as stocks. These are shares that represent an ownership stake in the company. Owning stock means we own a percentage of the total assets and cash of the company, but it doesn't mean we get a chair in a conference room. Since there are many types of companies, stocks are often classified even further based on market capitalization, industry, and geography.

Equity allow us to invest in businesses

When we own equity, we can make money when the share price rises and when we receive dividends. Overall, stocks tend to be riskier than cash and fixed income but have provided higher returns in the long run. However, risk and return for stocks can vary significantly because of many factors, including the company's size, sector, and geography.

Alternatives

Alternative investments represent the most diverse asset class. We can think of it as a mixed bag containing the more unconventional assets like commodities, collectibles, real estate, and cryptocurrencies. Hedge funds, private equity, and venture capital fall under this category as well.

Traditional art or NFTs can be thought of as an alternative asset

In general, most of these assets tend to have relatively fewer regulations than stock or bonds, making them somewhat riskier. Also, they are usually more illiquid, making them harder to sell and turn into cash. An attractive benefit of alternative assets is that they can help significantly lower our risk through diversification because their prices are more unrelated to other assets like stocks and bonds.

Commodities

These alternative investments are mostly raw materials or agricultural products. 

Commodities are required world wide

We can invest in them through ETFs, but their role as key ingredients for other products means their prices likely impact our other investments. 

Commodities example
  • Coffee beans: The coffee market is enormous; well over $400B globally! Roasters like Starbucks around the globe are sensitive to the price of coffee beans. They might buy large amounts of beans ahead of time if they think the price of beans will go up. They often sell excess beans to other roasters.
  • Crude oil: Refineries like Valero rely on buying barrels of crude oil to manufacture gasoline, so their business depends upon the price of oil. They usually buy it at a fixed price on a predetermined future date to lock in their costs to produce gasoline and other petroleum products. This protects them if prices rise in the future, perhaps due to a cut in OPEC oil production or turmoil in the Middle East.
  • Rare earth metals: Gold has been valuable for thousands of years with many uses. Investors typically treat it as a safe alternative to cash during economic uncertainty, such as downturns or recessions.

Collectibles

Collectibles are items that are worth far more than their original sale price. What makes them different are the powerful nostalgia and emotional factors that drive their value. Authenticity and condition are important as well. It's worth significantly less if there is a scratch or tear than if it's in perfect condition.

Collectibles examples
  • Stamps: The small pieces of paper that pay for postage can be incredibly valuable. In 2014, the British Guiana One-Cent Magenta sold for almost $9.5 million.
  • Sneakers: Some sneakers are considered collectibles and can quickly increase in value in some cases. For example, Yeezy 2 Red Octobers sold for $250 in 2014 and, in 2021, are worth over $10,000.
  • Vintage cars: Most cars don't increase in value; however, vintage cars are collectibles that can appreciate over time. The 1962 Ferrari GTO is the most expensive Ferrari sold for $48.4 million in 2018.

Real estate

Real estate is another valuable asset that has been around forever. It's the land (plants/trees, water, minerals in the ground) and anything permanently attached to it (houses or buildings). 

Real estate includes homes

We can earn profits from this type of asset by:

  1. Collecting rent from others who want to borrow it, to either live on or open a business.
  2. Producing stuff for us to sell through farming or mining.
  3. Its price went up due to scarcity - there is a limited amount of space out there.

Cryptocurrency

Crypto, like Bitcoin, is an alternative digital form of currency for a new decentralized financial system. The technology is still very early stage with tremendous uncertainty about regulations and doubts about widespread use. This makes buying or using coins and tokens on any practical blockchain application very speculative and high risk.

Cryptocurrency example
  • Bitcoin (BTC)
  • Ethereum (ETH)
  • Stablecoins
  • Non-fungible tokens (NFTs)

Derivatives

A derivative is unique because its value today depends on what the price of something else will be in the future. 

Contracts are often derivatives

They are contracts between two parties regarding the future transaction of an asset, specifying how much, on what date, and at what price. So, the price of a derivative depends on the underlying asset's price relative to the price set in the contract. When the asset's price changes, the value of our derivative will change accordingly.

Derivatives are the most complex and riskiest asset class. They can be used to speculate, but we can also use them as insurance to protect against potential losses from our other investments.

Here are a couple of derivatives we're likely to come across
  • Stock options: We might be granted stock options at work or buy stock options through a broker. Options represent the right to buy or sell shares of stock at a specific price on a future date. The value of a stock option goes up and down in correlation based on the company's value.
  • Season tickets: Season tickets are contracts between the team and the buyer for seats to all of the games in a season. The price of the season tickets derives its value from the underlying asset, the seat. If the team makes it to a championship, the value of that seat goes up, making the season ticket more valuable.
 

Actionable ideas

Investing across these asset classes provides you with more diversification benefits, lowering your overall risk. Most people invest in cash, stocks, and bonds; however, many companies have made investing in alternative assets significantly easier.

Use the nature of each asset class to your advantage in building a portfolio that suits your risk tolerance and investment goals.

  • If you have a high risk tolerance and are investing for a retirement that's decades away, it would make sense to invest more in stocks than bonds and cash.
  • On the other hand, fixed income and real estate might be more relevant to you if you have a low risk tolerance and want your investments to give you a monthly income.
  • Perhaps you have plenty of extra cash that you don't mind losing; you might be more interested in speculating with cryptocurrencies and derivatives.
 

Supplementary materials

Check out this short video for an overview of asset classes
https://www.youtube.com/watch?v=tbPT2FpDkFU&ab_channel=NapkinFinanceNapkinFinance

Glossary

What is Asset class?

A group of investments with similar characteristics, often having comparable risks and returns. The investments are usually traded in the same markets and follow the same rules and regulations.

What is Asset allocation?

How a portfolio is divided among different asset classes. 

What is Real asset ?

Investments that we can touch or hold that have an inherent physical worth from having uses outside of being an investment, such as commodities, real estate, equipment, and collectibles.

What is Financial asset ?

Investments that aren't physical but have value from contractual rights, such as cash, stocks, bonds, and derivatives.