Every investment belongs to what is known as an asset class—a group of investments that have important features in common.
Generally, each asset class:
Puts your money to work in different ways
Provides a different level of long-term return
Exposes you to different types of risk
Reacts differently from the other classes to what’s happening in the financial markets and the economy in general
The major asset classes are equities, fixed income, cash and its equivalents, and real estate.
You make an equity investment when you buy shares of stock in an individual corporation or shares in a mutual fund or exchange traded fund (ETF) that owns stock in a number of corporations.
There are two ways to make money with equity investments—by selling at a profit or by sharing in the corporation’s earnings, typically through dividends the corporation may issue.
The risk with equity investments is that the prices may be volatile—they can change significantly in a short period of time—and neither their market price nor the income they may provide is guaranteed. This means you could lose some or all of your money in an equity investment, especially if its price dropped suddenly and you sold your shares.
When you buy a bond, you are effectively lending money to the bond issuer, such as a corporation, a government, or government agency. The issuer pays you a pre-determined amount of interest on a scheduled basis—hence, fixed income. When the bond comes due, or matures, the lender pays you back the face value of the bond.
Bonds are often bought and sold before they mature. If interest rates rise, the value of bonds you own will fall since newer bonds will pay a higher rate. Just the opposite happens if interest rates drop—the bonds you hold increase in value.
One of the major risks of bond investing is inflation, which eats into the value of the fixed payments the bond makes over time. To mitigate this risk, you might consider two types of government bonds that are designed to protect investors from the effects of inflation:
I-Bonds, which are inflation-adjusted U.S. Savings Bonds, that pay interest based on both a fixed rate and inflation rate that is adjusted twice a year.
TIPS, which are Treasury Inflation-Protected Securities, that pay principal-based interest that is adjusted for inflation. So as inflation increases, so do the interest payments.
You can also invest in fixed income by buying bond mutual funds or ETFs that invest in a portfolio of bonds. While the return is based on the performance of the portfolio—not on a specific interest rate—these funds can provide a diversity of fixed income holdings that mitigates the risk of owning just a handful of bonds.
Cash and Its Equivalents
Cash is the money you hold in your wallet, and your savings and checking accounts. Cash equivalents, which are highly liquid, include short-term CDs (certificates of deposit), U.S. Treasury Bills, and money market mutual funds. Bank savings accounts and CDs are insured up to certain limits and Treasury Bills are backed by the full faith and credit of the U.S. government.
While cash equivalents typically pay low interest rates that won’t protect you against inflation, there are good reasons to keep part of your portfolio in cash—for example, as a reserve for emergencies or as a pool of funds you can draw upon when you need the money but don’t want to sell off other investments at a loss.
You can invest in commercial real estate, such as office buildings, apartment complexes, and shopping malls, by buying shares of a publicly traded Real Estate Investment Trust (REIT).
The more varied a REIT’s properties are, either by type or geography, the greater the protection it has against downturns in the real estate market. Typically, a REIT must distribute at least 90% of its taxable income to shareholders, so investors may be attracted to REITs’ stream of income. But, remember, income from REITs is taxed at a higher rate than the rate that applies to dividend income from stocks.