While there are countless investments to choose from, we can group them into 5 main categories or asset classes: Cash, Fixed-income, Equities, Alternatives, Derivatives.
Let's walk through each, in order of least to most risky, and look at some examples.
Sometimes referred to as cash and cash equivalents, this asset class is the most familiar.
We know it as the paper bills in our pockets and coins in our piggy banks.
The advantage of cash is its liquidity, meaning we can quickly access it at any time. However, it offers the lowest risk and lowest returns.
The investments in this asset class are usually bonds, so most of the return is from interest payments.
Bonds typically have set, or fixed, interest rates which make returns somewhat stable and predictable. Although, there are a few types of bonds where the interest rate changes over time. Owning a bond means we are entitled to the money from interest and principal payments.
Bond values are more sensitive to some factors, such as changes in the inflation rate or the interest rates set by the Federal Reserve (US central bank). The interest rates we receive from bonds provide a higher return than cash. Fixed-income investments tend to be safer than equities because they would get paid back first if a company goes bankrupt.
Equities are usually referred to as stocks. These are shares that represent an ownership stake in the company. Owning stock means we own a percentage of the total assets and cash of the company, but it doesn't mean we get a chair in a conference room. Since there are many types of companies, stocks are often classified even further based on market capitalization, industry, and geography.
When we own equity, we can make money when the share price rises and when we receive dividends. Overall, stocks tend to be riskier than cash and fixed income but have provided higher returns in the long run. However, risk and return for stocks can vary significantly because of many factors, including the company's size, sector, and geography.
Alternative investments represent the most diverse asset class. We can think of it as a mixed bag containing the more unconventional assets like commodities, collectibles, real estate, and cryptocurrencies. Hedge funds, private equity, and venture capital fall under this category as well.
In general, most of these assets tend to have relatively fewer regulations than stock or bonds, making them somewhat riskier. Also, they are usually more illiquid, making them harder to sell and turn into cash. An attractive benefit of alternative assets is that they can help significantly lower our risk through diversification because their prices are more unrelated to other assets like stocks and bonds.
These alternative investments are mostly raw materials or agricultural products.
We can invest in them through ETFs, but their role as key ingredients for other products means their prices likely impact our other investments.
Collectibles are items that are worth far more than their original sale price. What makes them different are the powerful nostalgia and emotional factors that drive their value. Authenticity and condition are important as well. It's worth significantly less if there is a scratch or tear than if it's in perfect condition.
Real estate is another valuable asset that has been around forever. It's the land (plants/trees, water, minerals in the ground) and anything permanently attached to it (houses or buildings).
We can earn profits from this type of asset by:
- Collecting rent from others who want to borrow it, to either live on or open a business.
- Producing stuff for us to sell through farming or mining.
- Its price went up due to scarcity - there is a limited amount of space out there.
Crypto, like Bitcoin, is an alternative digital form of currency for a new decentralized financial system. The technology is still very early stage with tremendous uncertainty about regulations and doubts about widespread use. This makes buying or using coins and tokens on any practical blockchain application very speculative and high risk.
A derivative is unique because its value today depends on what the price of something else will be in the future.
They are contracts between two parties regarding the future transaction of an asset, specifying how much, on what date, and at what price. So, the price of a derivative depends on the underlying asset's price relative to the price set in the contract. When the asset's price changes, the value of our derivative will change accordingly.
Derivatives are the most complex and riskiest asset class. They can be used to speculate, but we can also use them as insurance to protect against potential losses from our other investments.
Investing across these asset classes provides you with more diversification benefits, lowering your overall risk. Most people invest in cash, stocks, and bonds; however, many companies have made investing in alternative assets significantly easier.
Use the nature of each asset class to your advantage in building a portfolio that suits your risk tolerance and investment goals.
- If you have a high risk tolerance and are investing for a retirement that's decades away, it would make sense to invest more in stocks than bonds and cash.
- On the other hand, fixed income and real estate might be more relevant to you if you have a low risk tolerance and want your investments to give you a monthly income.
- Perhaps you have plenty of extra cash that you don't mind losing; you might be more interested in speculating with cryptocurrencies and derivatives.