The Asset Classes That Can Make Up an Investment Portfolio
By Jeff Cuellar, 10 April 2018
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Asset Classes, Risk Appetite and Diversification
In general, an asset class is a group of securities that have similar investment characteristics such as the level of risk and performance in different market conditions.
We’ll get into the different types of asset classes in a bit — but first, let’s briefly cover risk appetite and diversification, as they will have a direct impact on what type of investment portfolio you can build.
Risk Appetite
Risk Appetite is the amount of risk you are willing to take in order to achieve your investment goals. Generally, investments that can provide higher returns are riskier — while lower risk investments typically provide lower returns.
Your risk appetite is a bit like your “heat” tolerance when it comes to adding chilli padi to your food. For instance, a person who suffers from heartburn is only comfortable adding a little chilli padi to taste. On the other hand, someone who loves chilli padi will probably be more willing to take the risk of spiciness and add quite a bit of chili padi to his or her food.
A person’s risk appetite is tied to a variety of factors such as life stage, time horizon, income, savings, and expenses. Everyone has different levels of risk they are able to stomach. According to financial experts, people closer to retirement tend to have a lower risk appetite than young people in their 20s and 30s who are beginning to plan for retirement and have at least 20 working years ahead of them.
Diversification
Diversification is an investment technique that manages the risk of an investment portfolio by making investments in multiple asset classes in multiple industries and/or categories. This goal is to create a portfolio that balances your risk appetite with your investment goals.
Let’s apply diversification to a delicious plate of chicken rice. An investment of $5.00 in a plate of chicken rice can be broken down into three “assets” — chicken, rice and chilli sauce. However, everyone has their own preferences as to what proportion makes up a “balanced” chicken rice dish. Some people may request less rice if they are cutting carbs, while others may add a larger proportion of chilli sauce to the dish if they can handle the “heat”. A diversified portfolio that’s “balanced” for one person may not be for another person — again, “balance” depends on a person’s risk appetite and investment goals.
Note: Don’t worry about feeling “late” to the investment game — check out our article on how to retire if you start planning in your 40s.
What Asset Classes Can You Use to Create an Investment Portfolio?
Asset classes are generally comprised of three main components — cash and cash equivalents, fixed income and equities.
Of course, everyone has his or her own “flavour” preferences. Investing is no different, as diversification and risk appetite will impact the “flavour profile” of the portfolio — which includes a variable mix of the following asset classes:
Asset Class: Cash and Cash Equivalents
Cash and cash equivalents can provide your portfolio with liquidity, stability and some inflation protection (read our article on the fear of getting older to see how dangerous inflation can be).
In general, this asset class includes the following:
- Savings Accounts: includes accounts that pay interest based on your deposit amount (e.g. 1% per annum on the first $10,000 in your account and 1.5% per annum on the next $20,000, etc.)
- Fixed Deposit Accounts (FDs): accounts that pay a fixed interest rate based on deposits made for a specific period of time (e.g. 1.2% per annum over a 24-month period for a deposit of $10,000)
Pros: This asset class is stable and secure, as the amount invested will not fluctuate much. It is also liquid and provides some protection against inflation (depending on the interest rate earned).
Cons: While safe, cash will not generate high returns as the interest rates are often at or below the annual rate of inflation, which is around 2%.
Asset Class: Fixed Income
Fixed income assets can include investing in bonds as well as bond mutual funds, certificates of deposit (CDs) and money market funds. They can do well enough on their own — but it’s when they are part of a diversified portfolio that they really shine as they can be a reliable source of investment income.
In general, this asset class includes the following:
- Government Bonds: In other nations, government bonds are a type of debt security whereby you’re “lending” money to help pay for government spending with the promise that it’ll repay your “loan” with periodic interest payments. Singapore Government Securities (SGS) on the other hand are a bit different in that proceeds from SGS issuance are not used to finance government spending, but are instead placed in a Government Securities Fund that’s generally limited to paying the principal and interest on SGS.
- Corporate Bonds: Unlike government bonds whereby you’re “lending” money to the government, corporate bonds are “loans” to private corporations that can be issued for 5 to 30 years and typically pay income twice a year. Corporate bonds have the potential to deliver higher returns than government bonds, but also have higher risk of default, depending on the credit rating of the bonds.
Pros: Fixed Income assets in general are a safer investment than equities as they are less susceptible to market volatility and the returns are less volatile. For bonds, there are also ratings that can provide a rough indication of the risk involved in investing (i.e. checking Moody’s or Standard & Poor’s).
Cons: Fixed Income assets such as bonds have relatively stable returns with lesser risk exposure as compared to equities and hence may deliver lower returns making them more vulnerable to inflation.
Asset Class: Equities
In your investment portfolio, equities (also known as stocks) have the potential to provide the greatest returns — but they also have the highest risk as well.
In general, this asset class includes the following:
- Common Stock: Common stock usually enables you to receive dividend income based on performance and the company’s discretion, have ownership in the companies you invest in and come with voting rights on some company decisions (e.g. board of directors elections).
- Real Estate Investment Trusts (REITS): Similar to mutual funds, REITS allow you to have exposure to investments in properties such as shopping centres, office buildings, hotels and more — enabling you to receive a part of the income these properties generate.
- Commodities: These are raw materials and goods such as energy, metals and natural resources. Some commodities, such as gold and other precious metals, can be purchased and held onto while others can be purchased through futures, ETFs or mutual funds that are related to a certain commodity (e.g. oil and gas mutual funds).
- Exchange Traded Funds (ETF): While not really defined as equities, ETFs are traded much like stocks. ETFs are a type of mutual fund that’s a collection of stocks, bonds and commodities that’s meant to mirror the performance of a particular index such as the Straits Times Index (STI).
Pros: Equities have the potential to provide the highest returns as compared to cash and fixed income assets. They also have a relatively higher liquidity than fixed income. Some equities are able to pay dividends as well.
Cons: Equities also have the highest risk, which could lead to a loss of investment and dividend income if a company underperforms.
Want to Know Other Ways to Build Your Wealth?
Congratulations — you now have a good overview of the major types of asset classes you can use to build your investment portfolio.
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