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Different asset classes for investment

11 Mins 27 Sep 2023 0 COMMENT

The investment universe is characterised primarily by the financial characteristics of a variety of different instruments during assessments of the viability of investing in them. It is an important topic, especially from the perspective of analysing the risk return profiles associated with each of these instruments, also known as asset classes. In this article, we will take a look at different asset classes for investment.

Let us begin by defining the term asset class.

An asset class can be defined as essentially clubbing a set of investments together which portray similar traits and financial structures and are governed by the same laws and regulations. Leadingly, the financial instruments which make up an asset class frequently exhibit similar market behaviour.

Different asset classes available to investors

Let us now go through the variety of asset classes which are at the disposal of investors, namely: cash, bonds, equities, real estate, commodities, and derivatives like futures and options.

Cash

Starting with cash, which is the most common and arguably the safest and most convenient form of an asset. Cash as an asset class is characterized by the liquidity it provides, as cash comes with an ease of access unlike any other asset class. You can earn around 3-4% by keeping the money in the savings bank account or earn about 5-6% by making a fixed deposit with a bank.

Bonds

Let’s now come to bonds, which is essentially a debt-based instrument and is known to pay a fixed rate of interest as return. Bonds are also known as fixed income instruments. A bond might involve a business or a government organisation, and the issuer of the bond will give the bond holder a predetermined interest rate in return for using their money. Once the maturity of the bond is reached, the issuer returns the original principal lent to it by the investor. Debt is considered as a stable asset class in terms of returns delivered. Companies usually utilise bonds to them to fund various business operations, like expansions into new geographies or launching a new product line. One of the primary factors which influence bond prices is the interest rate environment and bond prices are inversely proportional to the interest rate. It means bond prices fall with a rise in the interest rate and vice versa. The last three-year annual return of the S&P BSE India Bond Index return is 5.1% p.a.

Equities

Equity, also known as shares or stocks of a company, refers to the ownership of the company granted to the shareholder in proportion of the shares owned by the person. Wealth can be generated by investing in this asset class by 2 means, one by capital appreciation, which is the increase in the price of the stock overtime, and the second is through dividends, which is the act of the company distributing their surplus profits amongst investors. Equity is usually considered to be one of the riskiest asset classes, and leadingly, also holds the potential to generate the most returns as compared to other asset classes. However, risk can be reduced by investing long-term in a quality and diverse set of stocks. The last three-year return of the S&P BSE Sensex is 19.6% p.a.

Source: Please note that Sensex and Bond Index return is on 5 Sep 2023, as per the BSE website.

Mutual funds

One can also invest in equity and debt instruments through mutual funds.

Mutual funds are investment vehicles which pool together the money from multiple investors and invest this money in a diversified portfolio of securities. These securities can either be stocks or bonds, depending upon the type of the mutual fund. Within this, funds can be further classified according to their investment mandates, like whether they invest in mid cap stocks or large-cap stocks. Mutual funds are managed by professional fund managers who make decisions based on thorough research and analysis to choose which securities to buy and sell to fulfil the investment mandate of the fund. Mutual funds provide investors required diversification in their investments to manage adverse movements in the markets. The riskiness of the funds depends on the type of securities the funds invest in.

Exchange Traded Funds

Exchange traded funds, commonly known by the acronym ETFs, are investment instruments which are tradable in the markets, similar to equities. The purpose of ETFs is to provide investors an alternate mechanism to invest in an asset without requiring to purchase each instrument separately. ETFs might track different economic sectors or stock market indices like Sensex and Nifty, or other asset classes like bonds and commodities like gold. ETFs are also considered to provide more liquidity as compared to mutual funds as they can be bought and sold at any time during the trading hours and generally have lower expense ratios as compared to mutual funds.

Real Estate

Real estate is a type of tangible asset that includes buildings and the land they are built upon. It is considered an asset class because it can be bought, sold, and used to generate income, similar to stocks, bonds, and other financial assets. Investing in residential and commercial properties can yield rental income and capital appreciation. Real Estate Investment Trusts, popularly known as REITs, are another market-tradable instrument to invest in a pool of real estate properties. The Composite Housing Price Index of the National Housing Bank (NHB) has appreciated by 4.4% p.a. in the last three years.

Source: The housing price index return is till Dec 2022 and is taken from the NHB website.

Commodities

Commodities are raw materials and primary products that are traded in markets, such as metals, energy products and agricultural produce. They are considered an asset class because they can be bought and sold, and their prices can fluctuate based on supply and demand. However, commodity prices can also be affected by geopolitical events and natural disasters, making them a potentially volatile investment.

Derivatives

Derivatives can be classified as those financial instruments whose value hinges upon an underlying security, and they are typically used for hedging one’s risk exposures or for speculation. Derivatives can be considered as one of the most riskiest asset classes, holding the potential of delivering both exponential gains and exponential losses. Examples of derivatives securities are futures, forwards, options, and swaps.

One of the beneficial aspects of having a diversity of asset classes is that investors can avail the opportunity of diversification, which is essentially the practice of spreading one’s investments across different asset classes to reduce the overall risk. This is possible due to the fact that all these asset classes typically have poor correlations with each other, meaning that all the assets do not move in the same direction while a market goes up or down, thereby providing protection against capital erosion.

Conclusion

One should remember that the selection of an asset class and the eventual allocation of one’s capital across multiple asset classes should involve a thorough assessment of the investments and the risk taking ability of the investor, in order to generate wealth while potentially minimizing risks.