Introduction to Asset Classes
Asset classes are different categories of financial instruments or different investment vehicles (such as cash & cash equivalents, real estate, derivatives, fixed assets, investment in equities, etc.), which are categorized on the basis of similar financial characteristics of each group and the basis may include the purpose of holding the asset, returns generated from the asset or any unique characteristic of the said asset.
- The word “asset” means something of value or a useful thing. Asset has been defined as any resource having an economic value that any person owns or controls with the intention to receive a future economic benefit.
- Thus, asset classes are nothing but different categories of such resources. The groups are made with the intention of keeping similar types of assets together under one heading.
- The different classes of assets include investment into equity or equity-linked saving schemes, alternative investments, real estate, fixed assets, cash & cash equivalents, etc.
- Each asset class has its own objective, advantage & disadvantage.
- Is there any correlation between the different classes of assets? The answer is not necessarily. In some cases, there is a negative correlation between the classes.
- The different classes are basically made for easy identification & observation. Each has a different purpose.
Types of Asset Classes
The most famous asset classes are discussed as follows:
1. Cash and Cash Equivalents
- Cash means hard cash. Cash equivalents mean bank balance & highly liquid bank deposits which mature within 3 months from the reporting date. All such terms are collectively called cash & cash equivalents.
- Cash serves the purpose of immediate liquidity.
- The resource is easily accessible at the time of need.
2. Fixed Income Securities
- Here the investor expects fixed returns on the debt amount infused.
- The tenure of the fixed interest payment is fixed in the agreement along with principal repayment.
- Say, there is a 5-year bond with a 7% coupon rate. The company will pay you 7% per annum on the face value of the bond until 5 years. At the end of the 5th year, you will receive back your principal amount.
- Are coupons paid annually? The answer is not necessarily. Some companies have quarterly or monthly or semi-annual frequencies of paying the interest amount.
- Since the returns are fixed & carry a lower level of risk, the returns are close to bank fixed deposit interests. Every return has a correlation with its associated risk. Thus, lower risk implies a lower return.
3. Real Estates
- As the name implies, it is the real asset of any person who owns it. The reason is that owning real estate will also flourish you with “n” of opportunities in terms of returns, holding value, opportunity returns, status symbol, etc.
- Real estate ensures providing the capital gains multiples times the investment value.
- On the benefits front, accounting norms allow depreciation costs to be claimed as expenses in books of account. However, the market value goes on to increase with the time factor.
- As compared to other classes of assets, only real estate is considered to be visible to the naked eye due to its tangible feature. The majority of other classes of assets are financial instruments with intangible characteristics. That’s the reason why banks easily provide finance to companies with higher tangible assets.
4. Equity
- Equity basically means having a share of ownership in the company.
- Equity shares are issued by public companies, against the consideration received for investment.
- Shareholders are said to be owners of the entity. Thus, in case a company is the liquidation of the company, the outside liabilities are paid first. The equity holders are paid at the end if any asset is left with the company.
- If it is so, why do people invest in equities? The reason is simple. If you are an owner, you are eligible for enormous & extensive profit earned by the company. The returns are not in percentages but in multiple times the investment made.
- Risk & return go hand in hand. Since equities have the opportunity of return, it is flooded with a similar quantum of risks. Risk includes the business risk carried by the company.
- The equities market is further divided into small-caps, mid-caps & large-caps depending on the size of market capitalization.
5. Derivatives
- A derivative is a financial instrument that derives its value from an underlying asset. A change in the value of such an underlying asset automatically changes the value of the derivative instrument.
- Derivative instruments are the most volatile holdings in the world. It has a considerably high range of gain or loss value.
- Derivatives help remove the uncertainty over prices & help the investor to gain from the uncertainties.
- A strike price is something that is fixed at the time of the contract.
Importance of Asset Classes
- Management of different classes of assets is important for companies that look into future expansions.
- One side of the balance sheet is equity & liabilities. The other side of the balance sheet is assets. Thus, the capital structure of the company is reflected in the assets owned by the entity.
- Each asset class has its own importance in the corporate world.
- The cash & cash equivalents provide immediate liquidity whenever the company needs it. Due to its every-time availability feature, it has no return of its own.
- Investment in equities serves as a financing need of a company when it wants to take a loan by keeping such investments as collateral with the lender. In the absence of such assets, the company would have not received the easy approvals of loans.
- Derivatives are important for trading in the market in the hope of gaining from the price fluctuations of the underlying asset.
- Fixed income securities offer assurance about the minimum inflow of cash in the company. On maturity, the company receives the same or higher amount of investment.
- Real estate shows the existence of the company. Real estate includes factory buildings, leasehold improvements, freehold land, etc. Each real estate has an opportunity to gain for holding the same.
- As you can have a glimpse from the above discussion, one may easily conclude that each asset class has its own different importance in the finance world.
Advantages of Asset Classes
Let’s discuss the advantages of each class of asset one by one.
Cash & Cash Equivalents
- Readily available every time whenever the owner needs it.
- In case of downturns (like COVID-19), this ready cash is always helpful.
- A medium quantum of cash & cash equivalent is always appreciated by analysts.
- This is a temporarily parking of excess funds, till the company decides on its further investment plan.
Fixed Income Securities
- The fixed inflow of cash even if the economy is sliding down.
- Since an agreement has already been made, the borrower has to pay the same rate of interest even if interest rates have fallen in the market.
- The income component is always predictable.
- It is safer than investments in equities since it carried a lower level of risks.
- It is also considered a tool for diversification of portfolio & it balances the total portfolio of an investor.
Real Estate
- The market value increases. Thus, the unrealized gain is not taxed by the government until the asset is sold.
- Very high returns when sold at right time.
- It is one of the safest investments after fixed-income securities.
- Holding real estate also provides rental income to the holder.
Investment in Equity
- The returns are always astonishing.
- The investment can be easily sold in the stock market.
- Equity offers the right to vote in a general meeting. Votes are linked to the number of stocks held by a person.
- Returns are higher than fixed-income securities.
- Less complicated to sell than selling real estate.
- It provides an opportunity to earn dividend income.
Derivatives
- It has a high earning potential.
- It provides an opportunity to earn higher in a shorter span of time.
Disadvantages of Asset Classes
On the other side of the story, let’s discuss the disadvantages of asset classes one by one.
Cash & Cash Equivalents
- Zero rates of interest for holding cash in hand.
- The rate of interest for a very short-term period is never attractive. The opportunity cost of not holding the required cash is high sometimes.
- Too high or too low cash is always dangerous.
- Too high a cash balance implies, the inability of the company to park the money at attaining gains.
- Too low cash balance implies, lower liquidity.
- It does not protect from inflations.
Fixed Income Securities
- Lower flexibility to exit, in case of rates in the market has risen.
- Lower return than equity.
- The stream of cash flows is very slow. There is no growth aspect in the rate of interest.
- The rate is interesting and cannot be revised.
Real Estates
- These are held for the long term. The value diminishes in the books of accounts.
- Books of account do not allow to revalue as per the market value.
- Money is stuck for a longer period of time.
- In case real estate is sold, the shareholders of companies always question the stand taken by management. Thus, earning capital gain is not that easy.
Investment in Equities
- Most volatile investment.
- You may have to wait for years, in case the stock chosen by you does not have sound fundamentals.
- Capital gains are taxed separately at a separate rate of interest irrespective of marginal rates of tax.
- The dividend income is not attractive.
Derivatives
- Returns are volatile in nature.
- High return is associated with high risk.
- In most cases, the premium is absorbed by the time of the expiry period.
- Prices are very much dependent on the flow of the economy.
Conclusion
The percentage of investment in one asset class has implications on the overall return you will earn in near future. Thus, diversification is always at the center of discussion for every finance-oriented topic. The risk cannot be eliminated but it can be reduced to a very low only by diversification of investment into different categories. Risk means the chances of not earning a profit or losing the whole amount of investment. Every risk has a considerable return. Thus, the classification of assets into appropriate categories helps the reader understand the diversification of the entity.
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