Today I am going to teach you about “asset classes”, which is the most primary lesson every investor should go through. Understanding asset classes is very important for an investor because when you invest your money in any financial product, then in the background, it goes to a certain asset class only.
The world of personal finance has hundreds of financial products, which makes everything confusing for an investor, but if you understand which asset class it belongs to, then this whole world of personal finance will sound easy to you.
What is the meaning of Asset Classes?
Asset classes can be seen a big basket where all the financial products belonging to that asset class share a common characteristics. Things like risk, returns, liquidity and various other parameters are similar.
For example, a Fixed Deposit and PPF is different financial instrument, but at the deeper level they both are secure products, you do not lose money in these products, their returns are also predefined and there is predictability in their returns.
Can you see that both FD’s and PPF share some common characteristics? It’s because they both belong to the asset class “Fixed Income”.
There are 5 asset classes
While there is no standard list or category of asset classes, widely it’s accepted that there are 5 types of asset classes namely
- Fixed Income
- Real Estate
Every financial product you come across will fall into any of these 5 asset classes only. Each of these asset classes has their own set of behavior and they represent something unique about them. The chart below shows you financial products belonging to these asset classes and what these asset classes denote.
Asset Class #1 – FIXED INCOME
Let’s start with the most famous and favorite asset class of India, which is “Fixed Income”. Fixed Income asset class refers to the class of financial products where your investment amount is more of less protected and the returns are either fixed or predictable to a great extent. There is almost no/less risk in these products which are from fixed income asset class.
Investing in fixed income asset class is like lending your money to someone with assurance of return with predefined returns. So when you make a fixed deposit in a bank, you are not exactly “investing”, but lending your money to the bank with a promise that they will return back your principle amount along with a pre-defined interest.
Asset Class #2 – Equity
Equity asset class is an interesting asset class and slowly getting more and more acceptance from last 1-2 decades.
Equity means ownership
So when you invest in equity, it means that you have bought ownership into a business. For example, when you buy stocks of Infosys or Reliance, you become a small owner of that business.
Even the RSU and ESPP which you get from your company makes you a small investor in the company and that’s “equity investment”
Now obviously when you invest in business, you get a % ownership. And if that company becomes big someday in future, your overall worth also goes up. But there is a problem, the business grows only over time and in between there are ups and downs and that reflects in the stock price of the business/company.
If you look at all the rich people today (really filthy rich), it all happened with equity investor. Someone either opened their own company or invested in some company which was growing and held it over long term.
Asset Class #3 – Real Estate
Real estate, as we all know refers to physical space, or physical structure like land, residential flats, commercial spaces etc. These spaces are either used for living purpose or for doing the business and generate income. Should one invest in real estate or not is a topic of debate and I am not getting into that right now.
Over the last 2 decades, the real estate asset class has got tremendous interest from investors. Everyone wants to now own a home and real estate is very sought after asset class. As the country develops and expands, we see many upcoming areas in all cities and a location which was considered outskirt of the city becomes a very important location in the city and we see some amazing returns.
However the fact is that we always hear the “good” stories and never the bad stories where one got bad returns from real estate or lost their money.
Asset Class #4 – Commodities
Commodities refer to various types of physical goods or products which we all can buy and sell for various uses. Gold, Silver, Copper, Rice, and Oil etc will be counted under this asset class. The price of these products depend on demand and supply in the market.
Commodities are for “Trading” and not investing
With my limited understanding, I came to the conclusion that commodities are not for investing for long term, but mainly for trading, where you can benefit of the market cycles and predict demand and supply moves and get a profit or loss.
Returns from the commodities can be very volatile and each commodity has its own market and dynamics.
Only a handful of commodities like Gold or Silver can be invested in for a very long time because they can be stored without losing their usage. A common man can’t store other commodities in the same way, hence trading them for short term is a feasible option.
Asset Class #5 – Cash
When I say “cash”, I don’t just mean the hard cash bundles, but also the money lying in your saving bank account, or liquid mutual funds. I will refer all of these things as “Cash”.
The best thing about cash is that it gives you freedom to “buy” anything you want instantly. You can buy a car, a house or a phone or invest your money in other asset classes.
The freedom you get with cash is very high and that’s one reason why most of the people prefer to hold a lot of cash. Also the cash cannot be tracked (unless it’s several multi crore rupees) and many people keep their black money in form of cash.
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