Asset Allocation 101: What Are the Asset Classes and How Does One Choose?

The proper asset allocation can make all the difference in your portfolio. It can also help you achieve your financial goals, whether investing for retirement or building your down payment fund. There are various asset classes, but most investors focus on stocks, bonds and cash. Other investment vehicles, like real estate and commodities, are sometimes considered alternative assets.

Stocks

Stocks are a form of investment that represents ownership of a company. These shares represent a fraction of a company’s equity, and investors receive dividends, a percentage of a company’s profits when they buy and sell stocks.

Stock prices can fluctuate based on demand and supply. A stock’s price can also be affected by events outside the company, such as political uncertainty or economic cycles.

Investors can diversify their portfolios by investing in various stocks in different sectors and regions. This helps protect against losses in one area of the economy while enjoying gains in another.

Most financial advisors follow an asset allocation model based on goals and risk tolerance. For example, a 60% stock, 30% bond and 10% cash allocation might be appropriate for a retiree who wants to invest in a broad range of assets.

Bonds

Governments, municipalities, and corporations issue bonds to raise money from investors. They give investors a promise to pay principal and interest on a fixed date.

Bond rates and maturities depend on two main factors — the credit quality of the issuer and the time it takes to repay the bond. These factors are a function of the market and economic conditions and can be influenced by unexpected variables.

Investors can buy bonds directly, but banks and other financial institutions typically trade them. The price of a bond changes daily based on supply and demand.

Bonds generally offer a lower rate of return than stocks but also have the potential for higher volatility. This is why they are often included in asset allocation strategies, and investors should consider a diversified bond portfolio as part of their overall investing strategy.

Cash

The money in a company’s cash accounts is the lifeblood of the business, and companies need it to cover their operating expenses, fund capital expenditures, and invest in long-term growth projects.

Financial professionals typically suggest investors hold a mix of investments from three main asset classes: stocks, bonds and cash. The best allocation for you depends on your time horizon, risk tolerance and other factors.

Investing in cash and “cash equivalents,” such as savings deposits, certificates of deposit, treasury bills and money market funds, is often considered a low-risk option. The chances of losing money on these types of investments are meager.

However, it is also essential to recognize that cash and other similar assets can lose value over time due to inflation. This can have a significant impact on your overall investment returns. Depending on your risk tolerance, you may need to rebalance your portfolio occasionally to ensure your allocation reflects your needs.

Real Estate

Real estate is one of the most popular asset classes and can be used in many ways. It can include investments in single-family homes, apartment buildings, condominiums, etc.

Commercial real estate is another type of investment that can add to a portfolio. It can include office space, self-storage facilities, and industrial properties.

Retail is a sub-asset class in commercial real estate that includes everything from single-tenanted shops to shopping malls and strip malls. Unlike other real estate asset classes, retail buildings often have long lease terms that help investors avoid vacancies and uncertainties about future income.

It can be difficult to find commercial real estate that doesn’t contain some form of shopping, so this category is an excellent choice for investors who want a stable source of income that doesn’t have to worry about future tenant vacancy rates or lease renewals.