Asset classes types of Investment Diversification asset classes

Asset classes refer to distinct categories or types of investments that share similar characteristics, behaviors, and risk profiles. They are used to classify various types of financial assets based on their underlying properties, such as the nature of the investment, expected returns, risk levels, and regulatory considerations. Asset classes include but are not limited to stocks, bonds, real estate, commodities, and cash equivalents. Each asset class typically exhibits its own unique risk-return trade-off and tends to respond differently to market conditions and economic factors. Investors often diversify their portfolios by allocating investments across multiple asset classes to manage risk and pursue their financial goals. When it comes to investing, the big question to consider is where to invest and what kind of returns to expect. The answer to these questions depends on the investor’s risk tolerance and desired returns. 

Different asset classes offer varying levels of risk and return potential. Some popular asset classes include:  

1. Fixed income instruments
2. Equity
3. Real estate
4. Commodities such as precious metals

Let’s understand each in detail: 

1. Fixed income instruments

Fixed income instruments, such as bank fixed deposits, government bonds, and corporate bonds, offer a fixed return on the invested principal amount. These investments are generally considered to be safe, with little risk to the principal. 

However, the returns on these instruments can vary depending on the issuer and the level of risk involved. For example, government bonds are considered the safest investment because the government is unlikely to default on its payments, while corporate bonds carry more risk due to the possibility of the company going bankrupt. 

As of October 2022, typical returns on fixed income instruments range from 5-6%, while government bonds offer around 5.5% and some corporate bonds offer up to 9 or 10%. 

Equity investments involve buying shares of publicly listed companies, which are traded on stock exchanges such as the Bombay Stock Exchange (BSE) and the National Stock Exchange(NSE). 

Unlike fixed income instruments, equity investments do not offer a guaranteed return on the principal amount. However, they have the potential to offer higher returns, with Indian equities generating a compound annual growth rate (CAGR) of 12% or more over the past 10-15 years. 

Some well-run Indian companies have even generated CAGRs of over 20% in the long term. Investing in equity requires skill, hard work, and patience in order to identify good investment opportunities. 

Real Estate

Real estate investments involve buying and selling commercial and non-commercial land, such as vacant plots, apartments, and commercial buildings. These investments can generate income through rental payments and capital appreciation of the investment amount. Rental yields on real estate investments typically range from 2-3%, while capital appreciation can vary widely depending on location and market conditions.

Real estate transactions can be complex and involve legal verification of documents, and they often require a large cash outlay. It is difficult to measure the returns on real estate investments as there is no official metric for this asset class.

Gold and Silver

Gold and silver, also known as bullion, are popular investment options that have appreciated over the long term. Investments in these metals have generated a compound annual growth rate (CAGR) of approximately 5-8% over the past 20 years. There are several ways to invest in gold and silver, such as purchasing jewellery, investing in exchange-traded funds (ETFs), or buying sovereign gold bonds (SGBs). 

Comparing the potential returns on different asset classes, if an investor had invested in fixed-income instruments at an average rate of 9% per year (through an excellent corporate bond), the investment would have grown to around 3.3 crore rupees (INR) over 20 years. 

If the investor had invested in equities at an average rate of 15% per year, the investment would have grown to around 5.4 crore INR. If the investor had invested in bullion at an average rate of 8% per year, the investment would have grown to around 3.09 crore INR. In general, equities tend to offer the highest returns over the long term. 

Cryptocurrencies are not included in this comparison because they are not a regulated asset class and therefore carry a higher level of risk for investors. It is generally advisable to diversify investments across different asset classes through a technique called asset allocation. For example, a young professional with a high risk tolerance may allocate 60% of their investable amount to equity, 20% to precious metals, and 20% to fixed income instruments.

Here’s what you should note before investing: 

A retired person with a lower risk tolerance may allocate 80% to fixed income instruments, 10% to equities, and 10% to precious metals. Before investing, it is important to keep in mind that risk and return are directly correlated – higher risk usually leads to higher potential returns, while lower risk leads to lower potential returns. 

Fixed income investments are generally less risky but may not keep up with inflation, while equity investments are riskier but have the potential to outperform inflation over the long term. Real estate investments require a significant upfront cash outlay and may not be as liquid as other asset classes. Gold and silver are relatively safer investments but may not offer the highest returns.