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But if you held a portfolio of airline stocks and oil in March as the coronavirus pandemic broke out, you would have lost a lot on both. Like returns, past correlations don't guarantee future correlations, and must be taken with a grain of salt. Besides risk and return, liquidity must also be considered when deciding asset allocation.
It is more important for some investors than others, but generally higher liquidity is better, other things being equal. The asset class with best liquidity is cash liquidity is, after all, the ease of converting an asset to cash. There are assets with higher and lower liquidity within these asset classes, but generally, stocks, bonds and commodities are easiest to buy and sell. That said, there are some liquid investment vehicles with exposure to these less liquid asset classes — for instance ETFs and REITs real estate investment trusts.
Much of the diversification potential of different asset classes arises from their different sensitivity to the general economy. A recession means business profits decline and some companies make losses, or even go bankrupt. This results in lower dividends and lower stock prices. Equity investors lose money that said, the stock market usually bottoms several months before the general economy.
Economic downturn also affects some fixed income investments particularly riskier corporate bonds , but benefits others short-term government bond prices go up, as central banks cut interest rates. The effects on stocks and bonds have been thoroughly discussed in classical investment theory. What about the other asset classes? Real estate also does rather poorly in a recession, although the effect varies by type commercial is more sensitive than land , location, and the nature of the recession.
Leverage is often bigger problem than falling property prices themselves. Infrastructure investments don't do particularly well in a recession, but they tend to at least lose less than equities and real estate. The same applies to art and other illiquid assets — they lose less, or at least the losses are not as visible as on stocks, due to the illiquidity and lack of public market. Some commodities , like energy or industrial metals, can be heavily affected by a slowdown, while others are not.
Gold is known to often do well when almost all other investments lose money and is therefore popular for diversification. Hedge funds , being a diverse group, have mixed exposure to the economy. For instance, equity directional funds with net long exposure obviously lose money. Other styles, like macro or some trend following funds, benefit from the increased volatility and trading opportunities.
One effect a recession has on hedge funds is that it magnifies the variability within the asset class. Manager skill matters more when markets are volatile. In a recession, differences between individual assets within the same class are much greater than in peaceful times. This may not be true initially, especially if a recession or market crash is caused by a sudden shock coronavirus comes to mind , but when the "dust settles" the winners start to diverge from the losers.
For example, at the beginning of a credit crisis, all banking stocks fall. But over time it becomes clearer which of the banks will be hit hard and which will do OK, and their stock prices start to reflect that. High inflation is particularly bad for cash and fixed income — with one exception: inflation-protected bonds , such as TIPS Treasury Inflation-Protected Securities.
The effect of inflation on equities is mixed, depending on sector and time horizon. In the long run, equities represent solid protection against inflation. Bottom line: A diversified portfolio of stocks with some alternative investments should do well in high inflation if your time horizon is long. If you are more conservative, inflation-protected bonds are the best inflation hedge.
The tree major, traditional asset classes are equities stocks , fixed income bonds and cash. Examples of other asset classes include real estate , commodities , private equity , art , or insurance. There is no unified, universally accepted list of asset classes. That said, the sources which list 5 asset classes usually include the following:. Other sources list additional asset classes, such as private equity , hedge funds , infrastructure , or art and collectibles.
Some sources bundle these with real estate or commodities under a single asset class named alternative investments. Because different investors have different risk tolerance, time horizon, liquidity requirements, and other needs, no single asset class is best for all investors under all circumstances. Furthermore, different asset classes tend to perform differently in different phases of the economic cycle. For instance, equities stocks earn high return in the long run, but they can be volatile in the short run.
Therefore, they are one of the best asset classes to invest in for a long-term investor, but less suitable for those with shorter time horizon and greater risk aversion. It is often best to combine different asset classes in a portfolio. Depending on their correlations , multiple asset classes can significantly improve the risk and return profile of a portfolio.
See Asset Classes and Asset Allocation. Generally, cash and short-term treasuries are considered the least risky asset classes. That said, they don't protect the investor against inflation. In high inflation, as the value of money declines over time, the purchasing power of the same cash amount goes down.
Assets which have both low general risk and do well in high inflation include inflation-protected bonds, such as TIPS Treasury Inflation-Protected Securities. Generally, equities stocks , private equity and commodities are among the riskiest asset classes. That said, subclasses or individual assets within the same asset class can have very different risk.
For example, a small or micro cap stock is usually much riskier than a large utility or telecom stock with long history of consistent profits and dividends. Similarly, in private equity, a highly speculative early stage venture investment is riskier than a more mature company. Even in asset classes generally considered less risky like fixed income you will find very risky subclasses and assets such as high yield bonds.
Note that some assets within these asset classes are quite illiquid such as some small cap stocks or some corporate bonds , and some assets from generally illiquid asset classes like real estate have good liquidity such as some ETFs or REITs. ETFs are financial instruments and not considered an asset class. ETFs exist on different asset classes, for example:. See difference between asset class and financial instrument.
Gold is usually considered part of the commodities asset class, or its precious metals subclass. That said, because the definition and classification of asset classes is not unified, some sources consider gold itself a standalone asset class. One reason is that gold has a unique risk and return profile, which is very different even from other commodities, and it also has low correlation to most other assets.
This is a complicated question, to which both professionals and academics give conflicting answers. There are arguments both for and against currencies being a standalone asset class. A currency balance is cash, which is a widely recognized asset class. This would suggest currencies are part of cash and cash equivalents , and not a separate asset class. That said, if we define asset class as a group of assets with similar characteristics like risk, return, liquidity, or the way they trade , currencies fit this definition quite well — as long as we consider a currency an asset.
In countries with unstable domestic currencies, many people hold part of their savings in dollars or euros. There are dedicated currency trading desks in some firms, while others put forex under fixed income that alone is not a strong argument — many institutions put commodities under fixed income too, and few people would consider commodities part of the fixed income asset class.
Generally, you can consider currencies either a subclass of the cash and cash equivalents asset class, or a standalone asset class. Options and futures and other derivatives are instrument types and usually not considered asset classes. Options exist on different asset classes: option on stocks, currencies, commodities etc.
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Of course, any buffer against market volatility always works both ways. If your diversification into cash or fixed-income protects you from market crashes, it also limits your access to market growth. In short, your asset mix heavily influences your portfolio's risk level and its growth potential.
You can also manage risk by diversifying within the asset classes. This involves holding multiple equities and multiple fixed-income securities. You can and should be precise about this diversification for two reasons:.
As you think about how to diversify your portfolio, consider the various levels of risk you face. For example:. To wrap this up, here's some homework for you. Review what you know about these five investment vocabulary words: asset class, correlation, diversification, unsystematic risk, and systematic risk.
Then think about how to apply these concepts to your own investment portfolio. You'll know you've passed with flying colors when you're comfortable with your portfolio's risk and excited about its growth potential.
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