An asset from my very first article we know is something that puts money in your pocket. Mostly passively. Simply put an asset class is a collection or grouping of similar behaving assets. They might be similar in terms of how they perform, where they are traded, may be regulated using similar laws etc. As you progress in your financial independence journey, its important to understand different asset classes and re balance depending on your age.
Types of Asset Class
1. Fixed Income Assets
Few examples are things like bonds and certificates of deposits. Bonds are just a loan you give to a corporation or a government entity for a fixed period in exchange for a fixed rate of interest during that time. High quality bonds are usually low risk as compared to other forms of asset classes. Since they have a fixed rate of return, every investor closer to their retirement or based on risk tolerance should have certain percentage in bonds.
2. Equities
Also known as stock or security is a small share in a public company. Buying a share of a company gives you part of earnings the company earns annually. However, this class of assets is much riskier since there is no guarantee on the return on your investment. It can go to the moon or burn into the ground. Having said that, there have been many studies that prove in the long-term stocks are the single best performing asset over anything else.
3. Real Estate & commodities
Real estate can be in form of owning actual property and renting it out to gain money. There are also publicly traded securities called Real Estate Investments Trust(REIT’s) which buy law are required to give back 90% of their earnings to the shareholders. REITs can be companies that invest in data centers and rent them out, public offices, apartment complexes etc. REIT’s usually provide a very high dividend yield compared to other asset classes and are good way to diversify. Commodities can be precious metals like gold and silver etc.
Stocks are the single best performing asset class over a long periods of time
Check out this graph that compares the values of various assets since 1802. See how 1$ invested in stocks grows way more than any other asset class. Bonds grew in value too but not as much as stocks. Interesting to notice is how gold and other metals/commodities barely grew in that time which is a big deviation from what people usually buy gold for. Usually a bar of gold just remains a bar of gold. Doesn’t really grow in value. Also focus on how 1$ bill in 1802 is now probably half of what it was in 1802. This is mainly because of inflation if you remember from our previous article. This just goes onto show that its important to invest and have diverse type of assets to be financially independent and secure your retirement.
What asset allocation strategy to adopt?
With knowledge of various asset classes, how do we go about deciding what is right for us and in what mix? That all depends on one’s own situation, age, goals etc. Ideally one should have a mix of all the asset classes mentioned above in some varying percentages. Since stocks are very risky but usually go up in long term, its better to have more stocks if you are in your 20’s or 30’s since you can take on much more risk. Maybe 90-100% of your investments in stocks. Later in your 50’s and 60’s you might want to have a stable stream of income coming in from your investments and so you might want to have more money in fixed income assets like bonds. It’s essential to not just stick with 1 strategy and mix in your asset allocation. You must re-balance it as you move along in your financial independence journey. It all depends on your investment horizon, risk tolerance. Ask yourselves questions like will you be able to stomach a 30-40% drop in value? Do you have other sources of income? How good is your general knowledge about stocks and bonds and these assets etc.? Then decide how much money do you want in various types of assets and go on form there. One of the biggest advantages of diversifying among different asset classes is that you reduce your overall risk. Stocks could be in free-fall or may be depressed for 4-6 years but if you have bonds, you could continue to receive income form them during that time.
Let me know if you have any other questions or comments, type them below and I will make sure to reply to them.
