If you want to be a better investor, it’s very important for you to understand what an asset class is. The answer is very straightforward: it is a group of assets that react in a similar fashion to a variety of financial forces. What are examples of asset classes?
- Stocks or equities
- Bonds or fixed income
- Cash or cash equivalents
- Real estate or businesses interests
- Tangibles such as commodities
How an Asset Class Works
Consider stocks as an asset class. If all stocks are part of the equity asset class, that means they are all subject to similar forces. Of course not all stocks go up or down in lock-step fashion. But if (for example) the economy heats up, that improvement is going to help most stocks. The outcome will be far different depending on the stock (or mutual fund that holds stocks). But an improving economy will move most stocks in a similarly positive direction.
That’s not the case with the other asset classes. An improving economy might hurt bond prices because interest rates might rise (and when that happens, bond prices drop). That’s part of how bonds work – and they work very differently than equities do. That’s why they are a different asset class. Now, if interest rates rise, it doesn’t mean that every bond is going to drop in value. But it means that most bonds will be negatively impacted.
So as the economy shifts, different forces will be unleashed on each of the asset classes. Those forces will nudge the different asset classes in different directions. But most assets within an asset class will be moved in a similar direction. Again, there may be competing forces that move the particular stock or fund. That individual stock might move against the market. For example, XYZ Company comes out with a cancer cure the same day the market drops 200 points. XYZ could still do really well that day but maybe not quite as well as they would have had the market been in an uptrend. Capiche?
Now that you understand what an asset class is, what’s the next important thing to understand?
The next really important step for you to take is to understand how different asset classes work. What are positive factors for each asset class? What hurts each asset class? I gave you a brief introduction on how bonds work above. Equities are very different. They tend to rise over time as earnings rise. But over the short term, it’s very difficult to know how a particular stock is going to perform. Real estate markets behave differently based on local economies, but they are also impacted by national and international economics. Can you see how knowing a great deal about equity asset class investments won’t help you the least if you invest in real estate?
You can get an understanding of how these asset classes work for free on this and many other blogs. Before you invest, I strongly encourage you to master this understanding.
Why is it so important to understand how each asset class works?
If investing didn’t entail risk, it wouldn’t be important. You could just invest in the asset class with the greatest potential return and be done with it. But investing does have risk. And people lose a ton of money when they buy the wrong investment for the wrong reason, and they become very disappointed. Let me use an analogy.
If I went to the store and bought a hammer but started using it as a screwdriver, you’d probably think I was silly, and you’d be right. Well that’s exactly what happens with investments. People often buy one particular asset class, like an equity mutual fund, and expect it to perform like something else, such as cash or a cash equivalent. Then when the market dips, they freak and sell. Sound familiar? Another problem is when you buy a fund expecting to get one asset class, but you end up with an entirely different portfolio. That’s why it’s so important to read and understand a mutual fund prospectus.
Have you ever heard someone complain about their investment performance? Have you ever heard someone say, “Oh…I shouldn’t have bought that fund. I could have done better in the bank.” Of course you’ve heard this. Maybe you were the one saying this.
While I can appreciate the sentiment, the statement belies a misunderstanding of how investments really work.
The bottom line is clear. If you understand how each of these asset classes work, you’ll make smarter investments. You’ll buy them for the right reasons, and you’ll sell them for the right reasons. Understand how these asset classes work, and then make sure they fit your investment strategy.