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What are asset classes? Understanding different types of investments and how to diversify your portfolio
money.ca / money.ca
Updated: November 22, 2024
What is an asset class?
An asset class is a group of investments that share similar characteristics. Underlying investments within an asset class often respond similarly to market changes, and investors mix asset classes within their portfolios to achieve diversification and reduce risk. In this article, I’ll explain how the main asset classes work, and how you can use different assets to build a diversified investment portfolio.
Types of asset classes
Most investors are familiar with traditional asset categories, such as stocks, bonds and cash or cash equivalents.
However, you can also invest in alternative asset classes, including real estate, commodities, cryptocurrencies, hedge funds, collectibles and fine art.
Importance of diversification: You’ve undoubtedly heard the saying, “Don’t put all your eggs in one basket.” This cautionary phrase refers to avoiding putting all your resources into one area, including your investments. The best option is diversifying your holdings by investing in multiple asset classes.
For example, rather than investing all of your money in stocks, bonds or cash, you can reduce risk and achieve higher long-term returns by investing a portion in each type of asset. You can further diversify by adding other asset classes, such as real estate or collectibles.
Here’s a closer look at the most common asset classes.
The 5 main asset classes explained
How to use asset classes to build a diversified portfolio
Here are four essentials to building a diversified portfolio.
Understanding asset allocation
Asset allocation refers to the process of dividing your investment portfolio among various asset classes. How you allocate assets depends on many factors, including investment goals, time horizon and risk tolerance.
It’s critical that your investment portfolio has the proper asset allocation, so you can meet your financial goals.
Mixing different asset classes
Unless you have an incredibly short investment time horizon or zero risk tolerance, it’s a good idea to hold multiple asset classes in your portfolio. How you mix asset classes will depend on your investment strategy.
For example:
- A conservative investor might have 75% of their portfolio in fixed-income investments, like bonds, 5% to 10% in cash or cash equivalents, and the remaining 15% to 20% in equities.
- An aggressive investor with a long investment timeframe and high risk tolerance might invest 80% of their portfolio in equities, 15% in fixed-income and 5% in cash.
The aggressive investor is taking on more risk but still managing that risk by diversifying their investment.
A balanced portfolio would fall somewhere between conservative and aggressive.
Understanding your tolerance for risk
Before you invest, it’s important that you understand your risk tolerance.
Here are a couple of things to keep in mind. First, your risk tolerance can be different for different investments.
For example, a 30-year old investor might have a low risk tolerance when it comes to their emergency savings account, which they may need to access at a moment’s notice. But that same investor can have a high risk tolerance for the retirement investments that they won’t need to access for 30 years.
Also, your risk tolerance can change over time. Generally, as your investment time frame shortens, your risk tolerance will shrink.
Rebalancing is vital to success
Your investment portfolio is dynamic, meaning that it’s constantly changing. As the value of the underlying investments rises and falls, your asset allocation can shift.
To maintain the ideal asset mix, you must rebalance your portfolio regularly. For example, if the equity component of your portfolio has grown, you may find yourself taking on more risk than you had initially planned.
The solution would be to sell off excess equities, purchase more fixed-income or cash, or do a bit of both. Just remember that maintaining your ideal asset allocation is critical.
Choosing the right asset classes for your financial goals
Now that you understand how to use asset classes, let's look at how to mix them to hit your targets.
Short-term vs. long-term goals
When choosing an asset class for your investment, consider your financial goals.
For example, saving for a house down payment over two years would be a short-term goal. In this case, you should avoid investing in equities or alternative assets, which are better suited for long-term goals. Instead, find the best return on a cash or equivalent investment, like a high-interest savings account or short-term GIC. You’ll need the money in two years, so your priority should be the safety of the principal, not achieving market returns.
Income-focused investments
Unless you’re an incredibly aggressive investor comfortable with a 100% equity portfolio, you will want to include some fixed-income investments. This doesn’t mean you have to rush out, purchase a rental property and become a landlord. You can add fixed income by buying individual bonds, bond ETFs, or real estate investment trusts (REITs).
Growth investments
Growth investments, such as equities and various alternative investments, comprise the largest percentage of most long-term investment portfolios. This is because they offer the highest return potential over time. Of course, you must be willing to take on additional risk as a trade-off. But you can manage the risk through diversification across multiple asset classes. Also, the longer your time horizon, the more time you have to ride out any market fluctuations that are bound to occur.
How to get started with asset investing
If you’re new to investing, it can be challenging to know where to start. Here are the steps to follow to build an investment portfolio with the proper asset classes:
- 1.
Establish your investment goals and time horizon: The first step is to determine your investment objective. What is it you’re saving for? Is it a short-term goal, like a vacation, a major purchase, or a house down payment? Or is it longer-term, such as your kid’s college savings or retirement? Knowing your investment purpose will help you understand your time horizon, which is closely associated with the next step — determining risk tolerance.
- 2.
Determine your risk tolerance: One of investors' biggest mistakes is not understanding their risk tolerance, which can lead to poor decision-making. For example, I have seen investors invest heavily in high-risk equities, insisting they are willing to sustain large drops in their portfolios to earn higher returns over the long term. But as soon as the markets take a big hit, they panic and want to sell their entire investment.
They either don’t understand how the markets work or have a lower risk tolerance than they realized. Before selecting assets and underlying investments, be very honest about how you would respond in various scenarios if the markets drop, and understand your risk tolerance. - 3.
Figure out the proper asset allocation: Once you’ve determined what you’re saving for, how long it will take and how much risk you’re willing to assume, it’s time to choose your asset mix between equities, fixed income and cash or cash equivalents. The following sample asset mixes can provide a general guideline:
| Asset allocation by risk tolerance | Equities (e.g. stocks, ETFs) | Fixed income (e.g. Bonds, GICs) | Cash (e.g savings accounts, cash deposits) |
|---|---|---|---|
| Safety | 0% | 0% | 100% |
| Conservative | 10%-20% | 80%-90% | 5%-15% |
| Income | 25%-40% | 70%-80% | 5%-10% |
| Balanced | 40%-55% | 45%-60% | 5%-10% |
| Growth | 70%-80% | 20%-30% | 0%-10% |
| Aggressive growth | 90%-100% | 0%-10% | 0%-10% |
Asset allocation rule of thumb
A common rule of thumb for portfolio allocation by age is the "100 minus your age" rule (or its variations). It provides a simple way to determine the percentage of equities (stocks) you might hold in your portfolio, with the remainder allocated to fixed income (bonds) and cash.
Subtract your age from 100 to determine the percentage of equities, then allocate the remainder to fixed income or cash.
- Age 30: 70% equities, 30% fixed income and cash
- Age 50: 50% equities, 50% fixed income and cash
- Age 70: 30% equities, 70% fixed income and cash
Open a brokerage account and choose your investments
Now that you’ve selected your asset mix, it’s time to choose the underlying investments. While I won’t expound on the various investment types, there are many options, from individual stocks and bonds to mutual funds and exchange-traded funds (ETFs), managed portfolios (robo advisors) and more.
You can hire an investment advisor to manage your portfolio, but many Canadian investors choose to manage their investments through an online brokerage or robo-advisor platform. There are many brokers to choose from, but top trading platforms include names like Wealthsimple, Questrade, QTrade and TD Direct Investing.
| Wealthsimple | Questrade | QTrade | TD Direct Investing |
|---|---|---|---|
|
|
|
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◦ Zero commission trades on stocks and ETFs
◦ Easy-to-use app for beginners ◦ Start investing with no minimum balance |
◦ Low fees and no annual account charges
◦ Access U.S. and Canadian markets ◦ Powerful tools for active traders |
◦ Award-winning platform with research tools
◦ Free ETF purchases for easy diversification ◦ Extensive learning resources for investors |
◦ Trusted bank with robust trading tools
◦ Seamless integration with TD accounts ◦ Access to advanced market insights |
| Wealthsimple review | Questrade review | QTrade review | TD Direct Investing review |
| Go to Wealthsimple | Go to Questrade | Go to QTrade | Go to TD |
What if you just want to keep it simple?
To simplify the process, you could potentially achieve diversification entirely through stocks and stock funds. For instance, you could purchase individual stocks as part of your investment strategy, while also investing in funds that hold assets related to specific asset classes, such as cash equivalents or real estate. This approach gives your ample exposure to those asset classes without the need to directly own the underlying assets.
You can explore the different asset classes with your online broker to learn which ones are the best fit for your portfolio. For instance, using an online broker like Wealthsimple or Questrade, you can search for the fund you want to invest in.
Let’s say you want to invest in real estate and you’ve found The Vanguard FTSE Canadian Capped REIT Index ETF (TSE: VRE.TO). All you need to do is type in the ticker symbol (VRE.TO) in the search bar and you’ll then be brought to the investment’s main information page. From there you can opt to buy shares quite easily.
Option 2: Investing with a robo-advisor
A professional financial advisor can work with you to decide which assets are the best match for your investment goals but that comes at a price. If you’ve just entered the world of investing, another good (and more affordable) option is to try using a robo-advisor instead.
Robo-advisors, like Wealthsimple, JustWealth and Questwealth use advanced algorithms to create and diversify your portfolio based on your answers to a set of investing questions. They also charge a lot less than financial advisors – typically less than 1% compared to the usual 2-3% you’ll have to pay with a financial advisor.
Using a robo-advisor will save time and energy, but your asset class options will be more limited. Depending on the portfolio type you choose, you’ll have a certain blend of stocks and bonds. While the ETFs offered by Wealthsimple don’t necessarily include real estate, cash equivalents, or other types of asset classes, those investment types are embedded within the ETFs themselves. For example, the Vanguard Total US Market ETF will have broad exposure to US-based stocks, many of which include real estate.
Every investor’s portfolio looks different, as everyone has different goals and risk allowances. By starting with a robo-advisor, you put yourself in a position to get the maximum gain from your portfolio, no matter which asset classes you choose.
Review and rebalance your portfolio regularly
Once you’re invested, reviewing and rebalancing your portfolio periodically is essential. This doesn’t mean that you need to look at it every day. In fact, I don’t recommend that for most people. But you should review your holdings at least once a year, even quarterly, depending on your investment goals.
FAQ
With files from Chris Muller
Colin Graves is a Winnipeg-based financial writer and editor whose work has been featured in publications such as Time, MoneySense, MapleMoney, Retire Happy, The College Investor, and more. Before becoming a full-time writer, Colin was a bank manager for over 15 years.
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