“What kind of car do you own?”, someone might ask you. That question could be answered a number of different ways. What’s the year, make, and model? What’s the trim? Is it a coupe or sedan? Manual or automatic transmission? It helps to have an established categorization of well-known vehicle classes (i.e. SUVs, sedans, coupes, minivans, flatbed trucks, etc.). Within those categories there are known sub-categories like midsize SUVs, hatchbacks, electric or gas, etc. Just like cars, the different classes of assets available for purchase on the market can be categorized in well-defined categories and sub-categories. And just like a lot of people are not “car people,” a lot of people are not familiar with how different assets are categorized. It’s helpful to understand these various asset classes to know what it is you are buying when you put your hard-earned dollars to work. Knowing which class of asset to invest in is just as important as knowing what kind of car you are buying.
We’ve discussed in prior articles (read more here) the higher-level classification of securities (i.e. stocks, bonds, mutual funds, etc.), but the term “asset classes” and subcategories of those classes further break up securities into different buckets of investment types. As with anything, depending on whom you’re talking to there might be different terms that are used. Generally, nearly all securities fall under one of the following six broad asset classes:
US Equities are stocks of corporations based in the United States and contribute to the national Gross Domestic Product (GDP). US stocks have historically outperformed the rest of the world for nearly a century. There have been periods of under-performance and volatility, but the free market system, innovation, technological advancements, and robust market conditions in the US have led to arguably the most prosperous economy in history.*
International Equities are stocks of corporations based around the world, excluding US equities. Because this category includes the economies and companies of hundreds of countries, there are several sub-categories of international stocks. The simplest way to categorize international stocks is to divide them into those of developed markets and those of emerging markets. Developed markets, as the name implies, are countries that have an established, strong economy, and relatively stable market conditions. Emerging markets, on the other hand, are countries that do not have fully developed economies, but instead are rapidly growing and moving towards development. There are upsides and downsides to stocks of each sub-category, including risks and rewards that come from investing in a developed versus emerging market. International equities have historically not performed as well as their US counterpart. Despite this, many financial and investing experts recommend investors include some level of international stock exposure to their portfolio for diversification of assets. Others rebut the argument in favor of international equities by pointing out that, because we have a largely global economy, US stocks often have exposure to international market conditions because of the trading across borders.
US Bonds are bonds and similar debt instruments that are issued by the US Government, corporations, and municipal governments (known as municipal bonds). US Government bonds are often differentiated by the time to maturity, which is when the issuer pays back the principal amount on the bond. Generally, short-term bonds mature in 1-4 years, intermediate-term bonds mature in 5-10 years, and long-term bonds mature in 10-20 years. Bonds are generally considered a less volatile form of investment than stocks, and often generate favorable returns during economic downturns. Bond interest rates are largely affected by economic conditions and the Federal Reserve, also known as “the Fed”, the United States Government’s central bank. The Fed determines the interest rate at which banks may borrow from the US Government, which in turn drives the interest rates on bonds. Generally, there is an inverse relationship between current interest rates set by the Fed and the returns of stocks. When the economy’s interest rates are low, stock performance is generally higher, and vice versa. This inverse relationship helps to explain why bonds can perform better in recessionary periods (i.e. a market downturn).
International Bonds are bonds issued by foreign countries outside of the US. Depending on the country, international bonds can carry significant risks not found in the US. Still, some investors include international bonds in their portfolio for diversification of assets and to capture returns outside of the United States bond market.
Money Markets, while important, are generally less important to long-term investors because of their extremely low rates of returns. A money market account still usually offers higher interest rates than a savings account, but the difference is not too significant. For cash that is not invested in stocks, mutual funds, or bonds in a brokerage account, a money market fund is often where the cash is held by default. The primary activity of the money market is the transacting of money between banks, companies, and the US Government.
Alternatives is generally a catch-all term for any other type of security that does not fall into one of the five categories above. Commodities, precious metals, utilities, consumer staples, and retail are some examples of alternative investments available that do not fit exactly under the other categories of assets. Alternatives can provide a great opportunity for diversification, and there can also be debate on the role of them in an investor’s portfolio. Gold, for instance, has long been held by some as a standard for a safe asset to hold for troubled economic times. Others not in favor of gold often argue that demand for gold is largely speculative and has no built-in yield like a bond would have as a safer asset. Either way, alternatives can play a significant role as a major asset class in an investor’s portfolio opportunities.
If you want to become more well-versed in some of the various types of asset classes we have discussed, keep an eye out for news stories in the business section of your newspaper, the Wall Street Journal, Morningstar, or any other source. You would be surprised how often these various categories of assets come up in the current events of our global economy!
*It is important to note that the classification of US equities/bonds versus International equities/bonds is not meant to disparage the economies of other countries, like it is “us” versus “them”. The primary reason US securities are given their own classification is that the US economy alone contributes to nearly a quarter of the world’s GDP (source: GDP by Country).
Disclaimer: Past performance is no guarantee of future results, which may vary. Investing involves risk, including possible loss of principal. The value of investments and the income derived from them may fluctuate over time. All portfolio returns and scenarios presented are hypothetical and backtested. The opinions and views expressed by the author do not constitute investment advice or recommendation, and are provided solely for informational purposes, and are not an offer to buy or sell any securities.