A cohesive investment portfolio is used to grow your wealth over time. It’s important to have a diverse investment portfolio in order to not lose your purchasing power to inflation or economic downturns. There are various asset classes in an investment portfolio, and each asset class plays a distinct role in your portfolio. Owning multiple asset classes can help diversify your portfolio and mitigate financial risk. Let’s take a look at some major asset classes:
Stocks
Essentially, owning stocks means you own part of a public company. When the company does well, you can earn money in two ways. You can earn money through dividends, which is when a company shares their profit with shareholders either quarterly or annually. You can also make money by reselling your stock at a higher valuation. When a company does well, the value of the stock increases. This means you can sell this stock at a higher price than what you originally bought it for.
You can buy individual company stocks through a brokerage account, or you have the option to buy index and mutual funds. Index funds/mutual funds are a collection of multiple stocks, and you can read more about them here.
Investing in the stock market is the most popular form of investment, because it is easy to buy stocks with a simple push of a button. In general, the stock market has had historically great returns. In the past 50 years, on average, the stock market has returned an annualized ~8% return after inflation. The major downside with the stock market is that stocks can either increase or decrease in value. For this reason, it’s important to own stocks, but not have it be the only asset class in your investment portfolio.
Bonds
Bonds, on the other hand, will always increase in value from when you originally purchased them. When you buy a bond, you are lending money to an organization and in return receiving interest payments from them. For example, treasury bonds (T-bonds) are bonds issued by the government. This means you are lending the government money for a prespecified length of time, and they use that money for state/federal projects.
Usually, T-bonds pay a fixed interest rate known as a coupon rate. Here’s an example
T-bonds example
This means if you buy a $1,000 T-bond with a coupon rate of 4%, you will receive $40 a year from the government until the bond matures. A bond’s maturity date is when the government must repay the principal on the money they borrowed from you. So in the above example with a coupon rate of 4%, if you lend the government $1,000 for 30 years, on year 30 you would have earned $1,200 (30 years x $40) plus also receive your $1,000 back.
Though you may be able to make more than 4% return in the stock market, the major benefit of T-bonds is that it is a stable guaranteed income. The government has never defaulted on bond payments. For this reason, if you want to buy a bond I would recommend T-bonds.
That being said, there are two main downsides to buying bonds.
Downside #1
One, when you buy a bond, your money is locked into that purchase until its maturity date. You can sell your bond, but a lot of bonds have low demand when there are better returns in the stock market. In the case you need your money back, you won’t be able to access it. With T-bonds, for example, the maturity timeline is between 20-30 years. Only put money here if you can afford to not have it for at least this long!
Downside #2
The second downside of buying bonds is that often inflation outpaces the coupon rate of the bond. As an example, if inflation is 4% and your bonds coupon rate is 4%, you are effectively not earning money! This is because whatever you gained in interest has lost value as purchasing power. If this money was instead invested in the stock market for the long-term, it would on average make 8% after inflation.Â
For this reason, investors are typically very calculated on when they do/don’t buy bonds. Investors like to buy bonds when inflation is really high and the economy is rapidly growing. This is because the government tends to borrow more money for projects when the economy is growing. The government’s high demand for people’s money gets rewarded to bond buyers in the form of high coupon rates (sometimes upwards of 10%). This incentivizes people to buy bonds rather than invest in the stock market.
Certificate of Deposits
Certificates of deposits (CDs) are similar to T-bonds. But with CDs, you are lending money to a bank instead of the government. Banks use your money to lend to customers and also invest in other financial instruments. In return, you receive an annual interest until your CDs maturity date. The benefits of buying CDs are the same as the benefits of buying bonds. The difference is, with CDs, the coupon rate is typically lower and the investment horizon is shorter.
Some investors prefer buying CDs rather than bonds precisely because their maturity timelines are shorter. But, you can buy both CDs and bonds. For high returns, buy bonds with money that you are okay with not having for a long time. With cash you’ll likely want to use again soon, buy CDs.
Cash
Cash is without a doubt the most held and traded asset class there is. This is popular because it is highly liquid, meaning it is very easy to use it for goods/services in the form of transactions. Too much cash, despite being a good problem to have, is still a problem. This is because your cash is always losing purchasing power due to inflation. Your cash doesn’t increase or decrease in value, but inflation usually only goes up. So, if inflation is 6%, your cash has lost 6% of its purchasing power (not good). That’s the main reason investors put their cash towards other asset classes, like the ones already mentioned in this blog.
However, some cash is great. You can use it for everyday transactions, as well as keep money aside for when investing in another asset class becomes attractive. As per the example in the “Bonds” section, an individual can hold cash until the coupon rate for T-bonds is very attractive, like 10%. Saving up cash and being able to invest it into something that will give you higher than normal returns is a great reason to have cash sidelined.
Investors typically have cash handy and ready to invest in any of the asset classes mentioned in this blog, in case there are ever favorable and unique conditions that would entice investing. Examples include a real estate or stock market crash, where prices drop and you can use your available cash to buy bargain deals that will inevitably increase.
Real Estate
Investing in real estate means purchasing property/land with the notion that the value will increase over time. Some investors buy homes/properties and rent them out for consistent cash flow every month. Some investors buy homes, fix them up, and sell them for more than what they purchased them for. This is called “flipping houses”. The most popular form of real estate investing though is buying a personal home. It is highly debated whether buying a personal home is an investment, and we’ll discuss this in another blog.
There are two main benefits of real estate investing. One, it can serve as a hedge against inflation. This is because in the long term, property prices increase with inflation. When you buy a house and put money towards mortgage payments, you own less cash that is losing purchasing power, and you own more of a house that is increasing in value! When/if you sell the property (given you have owned it for over 7 years), you will likely sell it for more than what you purchased it for.
The second benefit is if you rent out a property you purchased, you can make monthly income from the tenant. Even if you bought the house with borrowed money from the bank, investors typically charge a rent that is higher than their mortgage payment. In essence, when a tenant is paying you rent, the tenant is paying your mortgage payment plus giving you some additional cash every month. There are some finance experts that disagree with rent being a stable form of income, and some finance experts that also disagree with buying an investment property with a mortgage. If you’re interested in learning a deep dive on real estate investing, I’d urge you to take this course by Symon He on Udemy.
Conclusion on asset classes
To summarize, stocks, bonds, CDs, cash, and real estate are some basic asset classes investors own. There are more asset classes we didn’t consider, like commodities (gold/silver) and cryptocurrencies. It’s worth noting that each of these asset classes is worthy of their own blog post because they are complex and require nuance when discussing.
Nonetheless, this blog explores the basic asset classes. None of these assets are better or worse than one another. Investing in any of them depends on your financial goals, risk averseness, and investment horizon (age). Someone close to retiring should have a different allocation of funds in their investment portfolio when compared to a 25 year old. In the next blog, we’ll discuss some tips on what asset classes are recommended given different investment horizons.