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Understanding asset classes is very important for an investor because when we are putting our money in some financial product, then it will ultimately go to a specific asset class only.
An asset class is a particular category of investment such as stocks, bonds, real estate or cash. Investing is a trade-off between risk and returns. Depending on our risk appetite, we choose to invest in a combination of asset classes that would optimize the returns or let us achieve our goals.
The world of saving and investment has thousands, if not lakhs, of financial products. With their difference in terms, conditions, tenure, a further investment of the corpus and much more. Making everything confusing for an investor. But if we understand, which asset class it belongs to, the basic premises. Then only we will understand the language. And be able to make good decisions.
Meaning of Asset Class
An asset class is a grouping of investments, based on their similar characteristics. They are subject to the same laws and regulations. Risk factors, tenures, taxation, liquidity, return rates, market volatility, and various other parameters are similar in securities belonging to one class. And different from other asset classes.
Financial instruments under one asset class would have comparable traits and go through similar market fluctuations.
Equities (stocks), fixed income (bonds) and cash equivalent or money market instruments are the three main asset classes. Currently, most investment professionals include real estate, commodities, financial (or future) derivatives and even bitcoins/cryptocurrencies to the asset class mix.
An expert investment advisor would explain and divide different investment tools into different asset classes. To help you decide about diversifying your portfolio. And you can earn maximum returns with minimal costs.
For example, a Fixed Deposit and PPF are different financial instruments. But, considering that you do not lose money in these products. So, you can say, at a deeper level, they both are Secure Products. Besides, they both come under the Fixed Income Group because their returns and tenure are also prefixed.
Similarly, equity mutual funds or direct stocks, both sound like different financial instruments. But they belong to the same category. Due to both of them being the high risk-return instruments. They both involve investing in a highly volatile market. And have the potential to multiply your investment amount many times over. They belong to the same asset class called “Equity”.
Types of Asset Classes: WealthBucket
1. Fixed Income Instruments
Fixed Income asset class includes the financial products where your investment amount is protected to a large extent. There is almost no/less risk in these products. It is as if you are lending your money to someone, from whom a predefined return (principal + interest), is assured.
You are just letting the institution borrow from you. Subject to certain conditions. Such as capital protection, pre-agreed returns, and liquidity.
To a great extent, their returns are either fixed or predictable. They generate a regular return and let you earn a regular income.
Due to zero risks attached to this class, your money is secure. And a steady return, based on simple interest, will be provided. As per the conditions of investing. Typically, Fixed Income schemes earn 7%-8% returns.
Fixed Income Group has debt instruments like Bonds, FDs, PPF, NSC, Recurring Deposits, Debt Mutual Funds, etc.
The most common and sought after scheme among Indians, fixed-income assets are the most trusted and oldest forms of investments. Their popularity is also boosted by the fact that they are simple and easy to understand financial products.
Risk is Less. If you are looking for a fixed return. And do not want to take any risk. This asset class is for you.
Fixed Deposits do not beat inflation. The 8-9% return, you are getting on your fixed deposits, are subject to tax.
We don’t realize that it’s only the pre-tax interest. Fixed deposits and other debt instruments are taxable. Subject to STCG or LTCG Tax as per the investment duration. So the actual post-tax returns come only in the range of 6-7%. And if you adjust the inflation of 8-10%, the returns become negative.
Goals to Fulfil: Buying a Car, Trip Abroad, etc.
2. Equity
Equity (also known as a stock or share) means you have part ownership of a company. A share in any company gives the shareholder a stake in the company and its profits or losses. Your ownership is directly proportionate to how much you have invested. When you buy more stocks, you increase your ownership and your share in the stake of the company.
Now if that company grows, in the future, your overall worth also goes up.
Stocks, generally, have a high risk attached to them. Even though they allow you to earn significant returns. They carry the risk of complete or partial loss of the investment.
But there is a problem, all businesses need time to grow. And, meanwhile, they go through many ups and downs. Moreover, their growth is also subject to market fluctuations. All this reflects in the stock price of the company.
Thereby, equity mutual funds, stocks, index funds, etc. have a high risk-high return profile and offer growth in the long-term.
Among equity mutual funds, Equity Linked Savings Scheme (ELSS) are the only tax-saving investments, that create wealth too. But they work well when you invest for the long term. Historically, they have provided a return of 16-18%. Choosing the top Fund House with a proven record is crucial to growth in this asset class.
Goals to Fulfil: Retirement Planning, Children’s Education, Buying Property, etc.
3. Real Estate as an Asset Class
Real estate asset class refers to physical space or structures like land & plots, flats & apartments, commercial spaces, commercial buildings, industrial areas, villas, etc.
The past 2 decades have seen an increased interest in this sector. This is partially due to lower Home Loan interest rates and easier availability. Everyone wants to and can afford to, own a home.
The higher interest in real estate investments is not just limited to the urban areas. But in semi-urban and rural areas as well. As the metros & other cities in India are expanding, the outskirts have also become important.
This sector has given some amazing returns.
However, investment in the property sector is rather unpredictable and needs a long investment duration.
There are many factors involved that are out of control of an individual investor. Such as city planning, city future, socio-political scenes, govt policies, and project movement. These are deciding factors about the returns a property generates.
The real estate market has its own ups and downs. Making the returns very volatile. and many more.
This asset class is not structured or monitored. Neither is it transparent. Though the govt. is trying to make it transparent and structured with the introduction of the RERA Act. But it still has a long way to go.
Investment in real estate is not readily accessible to the retail investor. You need a high lump sum investment amount. Despite having plenty of opportunities for making a lot of money.
4. Commodities as an Asset Class
Commodities are types of tangible goods or products which we all can buy and sell for various uses. Because they can be bought and sold, therefore they can be traded as well.
Gold, Silver, Copper, bronze, food crops, petroleum, etc are covered under this asset class.
It is advised that these be bought when the prices are down and sold when the prices go up.
The price of these depends on demand and supply in the market. The market undercurrents vary for each.
Commodities are for “Trading” and not investing
With trading, you can benefit from the market cycles. If you are able to predict demand and supply moves. And get a profit or loss.
Commodities as investment options are very volatile and each commodity has its own market and dynamics.
Only a handful of commodities like Gold or Silver can be invested for a longer duration because they can be stored without losing their usage. Other commodities cannot be stored in the same way. Especially by an individual small investor. Trading commodities for the short term is a more feasible option.
5. Cash and Cash Equivalents
Cash doesn’t just mean the hard cash in your wallet or home. But also the money lying in your savings bank account or liquid mutual funds. All these things are also referred to as “Cash”. They are also known as money market instruments.
It is an essential part of our investment portfolio. Because it gives us liquidity. To buy things we need instantly.
It’s not uncommon to see many lakhs lying idle in a saving bank account just for some emergency. Or because they don’t have faith in any investment schemes Or to use it without any restrictions at any time. Without getting tracked.
However cash and cash equivalents have one problem, they do not fight or beat inflation. A savings bank investment gets only 4% interest.
Goals to Fulfil: With Cash & Equivalents, we can buy a vacation, or a phone, or invest it in other asset classes.
6. Derivatives as an Asset Class
A derivative is a financial instrument whose value/price depends on the underlying asset or group of assets. It is a contract between two or more parties who have a right/obligation to perform according to the conditions of the contract. First, the underlying corpus is created. It can consist of one security or a combination of different securities. And its price is derived from fluctuations in the underlying asset. The value of the derivative changes as per the fluctuations in the value of the underlying assets.
Generally equity stocks, bonds, currency, commodities, interest rates precious metals, debt, foreign exchange, stocks indices, etc. form the underlying asset. These assets are commonly purchased through brokerages.
Four common examples of derivative instruments are Forwards, Futures, Options, and Swaps.
7. Alternative Investments
An alternative investment means unconventional assets. It is different from equity stocks, bonds, debt, and cash.
Investment avenues such as art, antiques, wine, hedge funds, precious metal, private equity funds, distressed securities, and P2P lending are collectively known as alternative investments. Or they can be bitcoins and cryptocurrencies.
These are held by institutional investors or high net worth individuals mostly.
They have a complex structure, valuation, and limited regulations. Each alternative investment has a different ticket size, risk, mode of investing and regulatory framework. For example, an investment in startups, hedge funds, early-stage ventures, and PIPE funds is possible through Alternative Investment Funds (AIFs) which are governed by SEBI regulations.
They generate exceptionally huge returns. If they do generate returns. They are highly illiquid and risky at the same time.
You may want to add alternative investments to your portfolio. Because they provide significantly greater returns as compared to traditional investments. But you must evaluate your risk appetite first. And invest in these accordingly.
Comparing Basic Asset Classes
| Factor | Fixed Income | Equity | Real Estate | Commodities | Cash |
|---|---|---|---|---|---|
| Liquidity | High | High | Very Low | Low | Very High |
| Beating Inflation | Not Much | Yes | Most of the times | Not Much | Zero |
| Volatility | Low | High | High | High | Nil |
| Small Investment | Yes | Yes | No | Sometimes | N.A. |
| Transparency | Good | Average | Low | Low | N.A. |
| Regular Investment | Possible | Possible | Not Possible | Not Possible | N.A. |
| Average Returns | 7-8% | 12-14% | Not Determined | 8-10% | 0-4% |
Diversification
Under normal conditions, diversification is a useful way to reduce risk. If you put all your money in just one investment and it performs badly, you could lose your money. Whether all or part of it. However, when you diversify, with a variety of different investments, it’s much less likely that all of them will perform badly at the same time. The profits from the investments performing well, offset the losses on those that do not.
A portfolio that consists of only 1 or 2 asset classes cannot be called well-diversified.
The purpose of having all or as many major asset classes represented in your portfolio is mainly to prevent investment disaster. It further helps you take advantage of the different strengths of each class and all the uprises of the market.
Diversification helps to reduce the non-systematic or firm-related risks, by allocating your finances across different asset classes.
Correlation: Correlation between two asset classes shows the direction in which both of them head towards, at any point in time.
A negative correlation means that when the value of one asset class falls, the value of other asset class rises.
For example, this behavior may be noticed between equity and fixed income during a market slump.
The main purpose behind diversification is to minimize overall losses as much as possible and keep the portfolio returns in line with your expectations. The concept is about not putting all your investment in one class, rather distribute them among multiple asset classes.
Diversification—or at least the degree to which you diversify—also varies as per the preference of the individual.
Asset Allocation is about how much amount should be put into which asset class. That involves fixing your investment objectives, knowing your risk appetite, time duration, etc.
Generally, investment in each asset class should be in alignment with the time horizon of your goals. Long-term goals should go with Equity. While Fixed income class is good for short-term goals.
Within asset classes, many sub-asset classes can help you fine-tune the kind of growth or stability, you want.
Now if you’re risk-averse, you might want to diversify even more or make sure you’re further diversified within 2 or 3 classes. With minor differences within one class.
Finalizing
Investment is a complex activity. That is the main reason behind so many of us let our money keep idle in a normal savings account. To avoid getting into complications. Besides, most of us do not have the time required to put into understanding the intricacies of all asset classes, as well as their sub-classes.
If you want to increase your returns, take benefits of the rising markets, but do not have the expertise of the financial market. Its time to visit WealthBucket.
Let the highly qualified professionals carefully select the appropriate mutual fund to invest for you. We offer personalized services in a huge variety of investment choices. Some of them are equity fund investment, Debt mutual fund, Large Cap mutual fund or Multi-Cap mutual fund.
For a quick chat call at +91 8750005655. or mail at contact@wealthbucket.in.
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