People build their careers for decades and save money in the pursuit of a smooth retirement or to meet certain financial goals. You could store money in the bank and let it accumulate over time, but you can get higher returns by putting your money in various investments.
Many consumers know that investing is a common path to long-term wealth. You put your money to work for you, and the power of compounding takes its course. However, it can be hard to keep track of all of the investment opportunities out there. While many investors know about stocks and real estate, other investments such as gold, crops, art and wine (yes, wine investing is a thing) can make the options seem complicated.
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Luckily, investors use asset classes to group the various types of investments. Key asset classes include equities, fixed income, real estate, commodities, cash and alternative assets. Knowing how asset classes work can help you construct a portfolio that aligns with your financial objectives:
— How do asset classes work?
— Why invest in asset classes?
— Why bother with other assets if equities perform the best?
— How much cash should you hold?
— How risk tolerance factors in.
— Monitoring your investments.
How Do Asset Classes Work?
Asset classes help consumers group different types of investments based on their similarities. For instance, investments in fixed income generate consistent cash flow for a set period of time. Many fixed-income assets have low risk, and some of them have virtually no risk, such as certificates of deposit and U.S. Treasury bills.
Equities are riskier than fixed-income assets. They give you partial ownership of a company, and investors get exposure to the company’s gains and losses. Mark Andraos, associate portfolio manager at Regency Wealth Management, mentioned equities as a promising long-term opportunity to consider, and the data backs him up.
“Equities are by far the best asset class for investors seeking higher returns. From 2008 to 2022, U.S. large-cap equities have been a leading performer, with annualized returns of just under 9% (as measured by the S&P 500). For those investors who are considered accredited investors or qualified purchasers, access to private equity (with capital drawdowns, lockups and substantial illiquidity premiums) could generate higher returns over a full market cycle,” Andraos says.
While the investments within an asset class possess similar qualities, some are riskier than others. A share of Apple Inc. (AAPL) stock and a share of AMC Entertainment Holdings Inc. (AMC) stock each give you partial ownership and exposure to gains and losses. However, stocks like AMC are riskier than stocks like Apple.
Why Invest in Asset Classes?
Investing in asset classes helps you get more mileage out of your money. If you keep your money as paper cash or leave it in a zero-interest checking account, your money will not grow. In fact, it loses purchasing power every year due to inflation.
Each asset class gives you the potential to grow your money. Looking back to Andraos’ previous comments, U.S. large-cap stocks have returned roughly 9% annually for 15 years. If you invested $10,000 and received that return for 15 years, your $10,000 would have turned into $36,425.
That’s the power of compounding at work. The investor in this scenario would have generated an extra $26,425 without making additional contributions. It’s these types of returns that make a smooth retirement more attainable.
[How to Become a Millionaire by Investing]
Why Bother With Other Assets if Equities Perform the Best?
Equities don’t always perform the best, but during a bull market, they tend to outperform most or all asset classes. However, equities usually carry more risk than other asset classes, and every investor must consider how much risk they want to incur.
Jaron Beach, financial advisor at Cetera Financial Group, offers guidance on what to keep in mind when spreading your money across asset classes. “Your risk tolerance should be determined based on what you are saving for and how long. For instance, if you are saving for purchase in one year, your risk tolerance should be much lower than someone saving for retirement in 20 to 30 years. CDs, Treasury notes or money markets are good options for those with a one-year time horizon, while those with a longer time horizon should consider investing in more volatile portfolios, like stocks, mutual funds and exchange-traded funds, or ETFs.”
If you want to hold onto equities, you may have to bear a 20% to 50% drop in value during a bearish market. The declines can be higher depending on which equities you choose for your portfolio. Other asset classes, like fixed income, have more protections in place to minimize how much investors lose from their assets.
Certificates of deposit are safer and offer guaranteed returns for your capital. They don’t outperform equities during bull markets, but they make losses more manageable during bear markets.
Andraos says that asset allocation plays a key role in your total returns. “An investor’s asset allocation is often considered the primary driver of portfolio returns, and it is widely accepted that asset allocation plays a significant role in determining a portfolio’s overall performance. Some studies suggest that between 60% and 80% of portfolio returns are driven by asset allocation, while only 20% to 40% are driven by security selection.”
How Much Cash Should You Hold?
Cash doesn’t go up, but it doesn’t go down in the short run, either. Although inflation bites into cash’s purchasing power, you won’t have to worry about your cash losing value tomorrow. Until recently, it could take several years for declining purchasing power to become noticeable. Inflation has been high for quite some time, but when it cools off, cash will be back to retain its value for a bit longer.
Investors understand they can generate higher returns by spreading their money across asset classes. However, these assets come with risks. If you are wondering how much cash you should hold compared to assets, Beach has some suggestions.
“The general rule of thumb is that if an investor is single, they should save six months of cash for emergencies. If married, they should keep three months of cash for emergencies. However, things can factor into this rule, such as whether the investor has a significant purchase coming up in the next one to two years. If so, they will be better off having more cash than the typical three to six months.”
Investors who stash cash might as well put it in a high-yield savings account. These accounts generate risk-free returns and can help you build toward savings goals sooner.
How Risk Tolerance Factors In
Regardless of which asset class is your favorite, Andraos recommends spreading your money across all of them.
“In my opinion, investors who are less risk-tolerant and want lower returns and less risk should not completely abandon any particular asset class, but rather size it appropriately relative to their risk budget. There is merit in having money in more than one asset class due to diversification, particularly between stocks and bonds historically. For investors who want lower returns and less risk, I would consider a greater weighting toward high-quality fixed income, CDs and cash.”
Investors should consider their risk tolerance before making investments. However, they shouldn’t let their risk tolerance keep them away from asset classes. Each of these investments works differently and can strengthen your retirement portfolio.
Monitoring Your Investments
It is important to keep an eye on your investments as you spread your capital across asset classes. The investment thesis for an equity, commodity and any other asset class can change over time.
Investors who feel overwhelmed about monitoring many assets may want to consolidate their capital into ETFs. These assets give you exposure to many investments that focus on a broad theme. For instance, you can invest in ETFs that focus on dividend stocks, tech stocks, fixed income, real estate, commodities and other investment opportunities.
Reviewing your portfolio each week and staying on top of the news can help you make savvy investments. You can then make adjustments to your portfolio based on asset performance and changes to your risk tolerance.
Spreading your money across asset classes gives you the potential for higher returns. Monitoring your investments can increase the likelihood of building a profitable portfolio.
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What Are Asset Classes? originally appeared on usnews.com
