Asset Classes: A Guide
November 5th, 2006 by Justin
Breaking the convoluted investment world into asset types is like cutting a steak into bite-sized pieces before eating. It increases manageability and prevents choking.
Without dividing things into assets, investors can’t diversify, manage risk, allocate assets correctly, or even select the appropriate type of investment for a given level of risk appetite. Traditionally, “stocks and bonds” is the basic chant of those listing asset groups. Short-sighted and old-minded investors may still break things into these two groups, but most have moved well past this point. In fact, it at times seems as though the number of asset classes is growing faster than the Chinese gross domestic product.
{One thing to keep in mind: this discussion is about assets from the investor’s standpoint. Assets and liabilities from the perspective of a corporation are a different matter.}
Here’s an attempt at a comprehensive list:
- Cash
- Cash equivalents (money market funds, e.g.)
- Short-term investments (T-bills, 90-day CDs, etc.)
- Bonds (Municipal, Corporate, Federal, Foreign et al)
- Real estate
- Collectibles/Art (wine, antiques, etc.)
- Commodities (physical goods only, i.e. grains, gold, oil)
- Equities/Stocks
- Foreign currency
From these basic groups spring hundreds of actual instruments from a share of common stock of General Electric to an option on a fixed-for-floating interest rate swap (delete term from memory immediately). The key to understanding what group an asset belongs to is identifying where the asset gets its value. REITs, or real estate investment trusts, get value from real estate as the name makes clear.
An option on a CME E-mini S&P 500 Futures contract is an option (read: derivative, skip to the next word) on a mini (read: small-sized, ignore this word) futures contract (read: another derivative) of the S&P 500 index (itself a group of 500 stocks and all you need to know). All the excess terminology is just that: excess. It tells you a lot of other important things, like whether you’ll be trading on margin or with cash, taking a lot of risk or a little, and whether trade will take place on- or off-exchange, but if all you’re after is the asset class, skip to the terms that matter (you’ll learn these with time).
To reiterate: the point of all of this classification and organization is simply to put things in bite-sized pieces, so that investors can quickly characterize each bit of their portfolio. At a glance, an investor can evaluate a portion of his/her investments according to risk profile, sensitivity to economic cycles, correlation with other investments, and volatility of returns.
What all of those terms and analyses mean is a subject for another article, but suffice it say that given the hundreds of thousands of financial instruments in existence, a portfolio is a steak best swallowed piecemeal.
