Every investment belongs to one or the other asset class. When you invest, it is vital for you to know where your money goes – to which asset class. Classification of asset classes has certainly made finance more manageable for the investor to comprehend. This article covers the following:
Introduction to Asset Class
An asset class is a collection of securities, manifesting comparable traits and goes through similar market fluctuations. Similar legalities almost always bind securities in one asset class. Experts put different investment tools in various asset classes to help investors diversify their portfolio quickly.
Risk factors, taxation, return rates, liquidity, tenures and market volatility differ according to asset classes. Hence, investors often rely on asset category diversification to earn maximum returns with minimal costs.
Types of Asset Classes
There can be numerous criteria to classify asset classes. You may classify them based on purpose, i.e. whether it is a consumption asset like oil and natural gas or whether it is an investment asset like stocks and bonds. You may also categorise them based on location or the markets like domestic securities, foreign or international investments, or emerging markets and developed markets.
However, for now, let us dive into the popular asset classes and explore their distinct characteristics and unique selling propositions.
Fixed Income
As the most popular among Indians, the fixed income asset class is one of the most trusted and oldest forms of investments. Fixed deposits and public provident funds (PPF) are two examples of this. However, is this an investment in any case? You are just letting the bank borrow from you under conditions of capital protection, returns in the form of pre-agreed returns and liquidity.
With zero risks attached to fixed income asset classes, you will not lose the money you invest. Moreover, you earn steady returns as promised at the time of investing. You may get 7%-8% returns on fixed income schemes, but they are not inflation-beating returns. Subject to STCG or LTCG as per the tenure, fixed income schemes only offer security and not wealth-growth.
Equity
An equity asset class is a fascinating one and has been gaining popularity in recent years. Investing in equity means to buy into a business – when you buy shares of a firm, you have a percentage of ownership. The only hitch is that it comes with a certain amount of risk. Any business takes time to grow, and it is subject to market fluctuations, which can impact the share price.
Among equity investments, Equity Linked Savings Scheme (ELSS) is the only tax-saving (under section 80-C) and wealth-building scheme with the shortest lock-in term of three years. However, equity investments (including ELSS) work well when you invest for the long run as they have historically delivered 16%-18% returns and rising above inflation. Choose an AMC with a proven record, if you are planning to invest in equities.
Real Estate
The real estate asset class, as the name implies, focuses on plots, apartments, commercial buildings, industrial areas, villas etc. The millennium has witnessed a growing interest in real estate investments, exacerbated by the launch of Pradhan Mantri Awas Yojanai.e. house for all scheme. This is not just in urban areas, but in semi-urban and rural regions too.
However, the property market can be somewhat unpredictable, and there are numerous factors like city planning, socio-political scenes, and project movement that decide the returns. This is one asset class that is not always structured or monitored.
Commodities
Commodities can be anything ranging from goods, properties or products that can be traded for different purposes. Gold, silver, bronze, food crops, petroleum, etc. are some examples of commodities under the asset class, and the market undercurrents vary for each. The price can rise or fall as per the demand. Merchandises are not meant for long-term investments unless it is gold or silver. Just buy when the prices are down and sell when the prices go up.
Cash and Cash Equivalents
These are also known as money market instruments.It is not confined to currency, but also idle money in a savings account or any other liquid schemes. Nothing gives more transactional freedom than cash. Many people are reluctant to invest money in savings account because they don’t have faith in any investment schemes or to use it without any restrictions at any time. However, it cannot beat inflation, and the returns too are negligible (not more than 4%). People often store away cash to evade tax as they are untraceable.
Derivatives
A derivative refers to financial security whose value depends on the underlying asset or group of assets. Standalone, the derivative has no value of its own, and its price is based on the fluctuations in the cost of the underlying asset. It is a kind of contract between two or more parties who have a right/obligation to perform according to the conditions of the contract. Commonly used underlying assets are equity shares,bonds, debt, foreign exchange, commodities, market indices and interest rates.
Alternative Investments
An alternative investment relates to a unique asset and is not one of the traditional asset classes like equity, debt, and cash. These are mostly held by institutional investors or high net worth individuals owing to their complex structure and limited regulations. These attempt to generate exceptionally huge returns but are highly illiquid and risky at the same time. Some of the alternative investments found in the capital markets are hedge funds, bitcoins, artworks and structured products.
Diversification and Asset Classes
A basic understanding of the various asset classes, which are available for investment helps to build a lucrative and well-balanced portfolio. A diversified portfolio comprises of different asset classes that reduce the overall risk, and the portfolio’s performance is not affected by the inferior performance of any single asset class. Diversification helps to reduce the non-systematic or firm-related risk of your investment portfolio by allocating your finances across different asset classes.
It happens when the asset classes in the portfolio are uncorrelated or negatively correlated. Correlation between two asset classes shows the direction in which both of them at any point in time. A negative correlation means that when the price of one asset class falls, the price of other asset class rises. Such kind of behaviour is observed between equity and fixed income; especially during a market slump.
The main idea behind diversification is to keep the portfolio returns in line with your expectations and minimise overall losses. It educates you about not putting all your investments in one asset class instead distribute them among multiple asset classes. The percentage of funds which should go into each asset class deals with the problem of asset allocation.
It means how you are going to distribute a fixed sum among all the asset classes in your portfolio, keeping your target rate of return and risk appetite in mind. Risk appetite is about the quantum of fall in the portfolio value that you will be able to digest at a given point in time. Based on it, you decide the asset allocation of your portfolio.
Conclusion
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