You've probably read or heard investment guidance about the importance of having the right asset allocation, but what exactly does this mean? One of the first steps in building a portfolio is to determine the best mix of assets that is suitable for your
Equities (stocks), fixed-income (bonds), and cash (or its equivalent) are three asset classes every investor should be familiar with when considering an investment strategy. While there are many asset classes, this article will focus on the primary three.
It also should be noted that each of these asset classes has unique risk and return attributes, which are important for investors to understand before choosing the specific investment types within those asset classes.
What are equity assets?
A company's equity is the amount of money that would remain if the company liquidated everything it had and paid off all of its debt.
You can invest in equities directly by purchasing individual shares of stocks or indirectly by investing in
A key difference between mutual funds and ETFs is that ETFs trade intraday on an exchange like individual stocks while mutual funds trade at the close of the market. To purchase shares of these equity investments, you'll need a trading account, such as a standard
What are fixed-income assets?
When an investor buys a corporate bond, they are loaning money to the corporation, which will use that money as capital for its daily operations and projects. The bond investor will receive a set amount of interest for a certain period, typically twice a year for between one year and 30 years. On the maturity date, the bond investor receives back the principal amount (the original amount invested).
The most common ways of investing in fixed-income assets are by directly purchasing individual bonds—from the issuing entity or via a brokerage account—or indirectly by investing in a mutual fund or ETF that has bonds in its mix.
What are cash assets?
- Certificates of deposit (CDs)
- Money market funds
- Treasury bills
- Treasury notes
- Commercial paper
These types of cash equivalents can be purchased through a brokerage account, directly from the U.S. Treasury, or from a bank. Investors also may hold cash and equivalents indirectly through mutual funds, which may have a mix of any or all three asset types as a means of diversification or meeting distributions and buying new securities.
The most common way for individual investors to invest in cash equivalents is through a money market fund, which typically holds a diversified mix of short-term fixed asset investments in its portfolio, such as treasury bills and notes and commercial paper.
How do these classes of assets differ?
Equities, fixed-income and cash assets have very few similarities but several differences. While each may be found on a company's balance sheet and are the main types of investment securities for individual investors, their similarities pretty much end there.
The differences primarily involve the degree of market risk associated with each of these assets and the expected return or rate of interest received by the investor over time. For example, stocks generally produce higher long-term returns than bonds or cash, but the risk of losing any portion of the principal amount invested is greater than that of bonds and cash.
What are their comparative risks & returns?
With investing, there is a risk-reward correlation among these asset types. Generally, the greater the risk, the higher the potential for profit or loss. Equities generally have a relatively high risk-reward attribute, which means investors may earn higher relative returns as a trade-off for higher relative risk compared to the other asset types:
- Equities (stocks). High risk, high return, short-term price volatility.
- Fixed-income (bonds). Medium to low risk, relatively stable price volatility. However, bonds lose value, particularly in a rising interest rate environment.
- Cash (and its equivalents). Extremely low risk, stable prices, but low returns, particularly in recent years when most money market funds offered no investment returns.
Although past performance is no guarantee of future results, history can be a good guide for expectations on long-term rates of return. Over the 91-year period from 1927-2018, the
Is there a way to choose the "right" assets?
Choosing the "right" type of assets depends on a few personalized considerations, including risk tolerance and time horizon:
- Risk tolerance. This aspect measures the degree of risk an investor is willing to take to achieve an investment goal. Financial professionals will often gauge this with a questionnaire about investment scenarios. For example, knowing how you may react if stock prices were to fall 20% over one month helps determine your
tolerance for risk.
- Time horizon. This is how long you plan to hold your investments. For example, if you are 40 years old today and want to retire and begin making withdrawals from your investments at age 60, your time horizon is 20 years.
These are among the types of determinations financial advisors make when engaging in the
What is asset allocation?
When investors are building a portfolio of investments, one of the primary goals is to end up with a diversified mix of two or three of the main investment asset types.
Asset allocations are commonly categorized in ways that refer to an investment objective. There are three; growth, growth and income, and income and principal preservation. Sometimes these are also called aggressive, moderate, and conservative, respectively and may describe the risk profile of a given investor.
- Aggressive, growth-oriented allocations. These generally have a heavy allocation to stocks and are sometimes the choice of investors with a high tolerance for risk and a long-time horizon (10 years or more). A hypothetical example allocation might be 70%-90% stocks and 10%-30% bonds.
- Growth and income or moderate allocations. These are often suitable for investors who accept low to medium returns in exchange for medium risk-taking. A hypothetical example allocation might be 40%-70% stocks, 30%-50% bonds and 0%-20% cash or equivalents.
- Income or conservative allocations. These are often a good fit for investors with a low tolerance for risk and a short time horizon (less than three years). These investors may also be near or in retirement. A hypothetical example allocation might be 0%-30% stocks, 40%-70% bonds and 0%-30% cash or equivalents.
The above asset allocations are examples and not recommendations. A
Three of the main types of asset classes are equities, fixed income, and cash and equivalents. For individual investors, these are more commonly referred to as stocks, bonds and cash. An investor's asset allocation, or mix of asset types, is the foundation of portfolio construction. Once the asset allocation is built, the specific investment securities are chosen.
Determining an appropriate asset allocation is a key aspect of financial planning and investment advice. Sometimes the smartest investment decision is choosing a