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Understanding Asset Classes

Becoming financially independent is a goal of many, but taking the steps to reach it is a whole different story. One way for you to fulfill this is through investing.

Investments are assets you acquire or buy with the intent of generating income from it in the future. The best thing is that there are many types of assets, and one or even a few of them might just be perfect for you.

But before you make a decision and choose which ones you are going to put your money in, it is important to know and understand the different asset classes.

Just the Nuggets

  • An asset is something of potentially increasing value that produces income in the short or long term.
  • A group of assets with similar attributes, governed by the same policies and laws, is called an asset class.
  • There are five main asset classes: stocks, bonds, cash and cash equivalents, real estate, and financial derivatives.

What is an Asset?

An asset is something with value that hopefully goes up in the future. It could be in the form of stocks, bonds, real estate, etc. that can be owned by a single person, organization, enterprise, or even a country. 

What is an Asset Class?

Traded in the same type of financial market, this group of investments have similar characteristics and are regulated by the same policies and laws. Assets in a class tend to behave alike in the marketplace, and their issuers possess almost identical organizational structures and processes.

Basically, these asset classes are broad, general categories of investment pots or baskets. Think of them as containers where you put your money into that will give it back in the future with a nice profit. Or, if you are unwise about your investments or sometimes even unlucky, you can also lose much or even all of it.

Types of Asset Classes 

There are several types of asset classes, and to distinguish one from the other needs a thorough understanding.

Stocks or Equities

This asset class represents ownership in a corporation raising funds for an expansion or project. The terms stocks and shares are used interchangeably, but there’s a slight difference between them. Stocks often refer to units of ownership of different entities, while shares are more associated with a single company.

Say you bought 10 stocks, it means that you bought 10 pieces of ownership of 10 different companies. Meanwhile, if you say you bought 10 shares, it means you bought 10 pieces of ownership of a specific corporation.

Stocks are usually transacted through the stock market like the Nasdaq Stock Market (NASDAQ) and the New York Stock Exchange (NYSE). You can open and fund a brokerage account with a firm or licensed broker for them to manage on your behalf. 

Another option is through private exchanges or directly from the company itself. However, in this case, government regulations should be followed to protect you as the investor and the issuing company.

Read more about buying stocks without a broker here

How You Earn as an Investor 
  • Dividends are paid out by companies when they have excess earnings. They may either come in the form of cash or additional stocks, usually released quarterly after the preparation of the financial statements. The amount you’ll receive depends on the number of shares you hold.
  • When stocks are sold at a higher price than when purchased, you earn profit called capital gains
  • Short-selling or shorting involves borrowing shares from a broker and immediately selling them with the belief that the share price will soon decline. When that happens, you can then buy the same shares back at a much lower price and return them. The price difference comprises your earnings. However, this is a riskier method than waiting for the stock price to increase (taking a long position).

Bonds and Other Fixed-Income Investments

These are debts owed to you by corporations or the government as a method of capital financing. In a sense, you invest in them by extending a loan. In return, you’ll receive scheduled fixed interest payments (coupons) over an agreed repayment period. Moreover, the principal amount is paid at the end of the repayment period called the maturity date

The most common form is the bond. It is a tradable asset, representing the unit of debt secured, that aims to protect the initial amount of your investment. However, bonds may have varying maturity dates and face values (par values)—the amount to be repaid upon maturity. The par value is usually set at $100 or $1000 when the bond is issued.

You can buy bonds from the stock exchange, a licensed broker, your bank, the US Treasury, or directly from the issuing corporation or government unit. 

But what happens if the corporation goes bankrupt? 

Fortunately, if the entity where you bought bonds from faces financial troubles and files for bankruptcy, you can at least expect to receive payment first before the shareholders.

How You Earn as an Investor
  • Interest payment or coupon is usually paid semiannually until the principal investment is repaid upon maturity. 
  • Just like in stocks, you can earn from bonds through capital gains.

Cash and Cash Equivalents

Cash, whether on hand or in a bank, is the money used to purchase goods and services as well as to pay off debts, in both local and foreign currencies. In the case of a business, it includes all currencies in its primary office or headquarters and in any of its branches. 

Cash equivalents include those assets that can be easily and quickly converted into cash. These are marketable securities with short-term maturity (three months or less) that can be easily sold or bought at the stock exchange or bond market. The list includes, but not limited to:

  • commercial papers – usually issued to fund the business’ inventories, payables, payroll, and other short-term obligations
  • Treasury bills – issued by the government representing a debt maturing in one year or less
  • short-term government bonds – have a maturity period of one year to three years
  • money market holdings – include investments which a financial institution, like a bank, manages and uses to invest in marketable securities with short-term maturities on the investors’ behalf
How You Earn as an Investor
  • You can earn interest from the cash in your bank. However, interest rates vary, and some banks may require an average daily balance for your bank account to earn. In the case of foreign currency, you can earn if the exchange rate you used in acquiring the foreign currency is lower than the prevailing forex rate at the time it is converted to your local currency.
  • Marketable securities, on the other hand, can also provide interest or dividends.

Real Estate and Other Tangible Assets

Real or tangible assets have inherent values based on their properties and substance. 

Real estate includes land, permanent structures, and man-made improvements as well as natural features like water and water bodies, trees, and minerals on it. You can choose to invest in any of the following: residential, raw land, commercial, or industrial real estate. You can invest in real estate for special uses like land for campgrounds, churches, hospitals, and the like. 

There are many benefits to well-selected real estate investments, which include stable and regular passive income while providing diversity to your investment portfolio. Real estate can also be used as leverage when you secure a loan or mortgage to finance your business and other activities. 

Other tangible or real assets include equipment, art, gold bullion, precious metals, commodities, antiques, art, and other collectibles. As with real estate, investing in real assets allows diversification in your investment portfolio. They are also a more stable investment but with lesser liquidity—meaning, you cannot easily and quickly convert them into cash without reducing their market price. 

Some tangible assets, like gold bullion, are also perceived to protect the investor from inflation. For example, the inflation-adjusted price of an ounce of gold has increased from $1,534.68 in September 2010 to $1,920.60 in September 2020. 

How You Earn as an Investor
  • In addition to the psychological fulfillment and personal enjoyment you derive from these investments, you can earn rental income, capital gains (by selling when the property appreciates or increases in value), and other income from the business activities on your property like entrance and other fees for the use of your campground facilities, for example. 

Futures and Other Financial Derivatives

Derivatives are financial contracts or instruments that generate payoffs from an underlying asset—the commodity to be purchased or sold. This means that their values are directly dependent and linked to the value of the underlying assets which could be stocks, foreign currencies, bonds, commodities, or any other financial or real asset. 

The reason why derivatives are much easier to trade than the asset itself is, the seller doesn’t need to own the underlying asset. They can deliver the contract to the client (owner of the asset) by paying them for the asset at the best price. They can also give the client another derivative contract that diminishes or offsets the outstanding balance of the previous contract.

Conditions are specified in the contracts pertaining to the term dates, the resulting or expected values of the underlying assets, and their total or notional amount if they are bought at current or spot prices.      

There are four kinds of derivatives. They can be acquired through the public stock exchange or over-the-counter (direct from the seller or through a third party).

1. Futures

These are considered the most important derivative. The terms of the contract are standardized, where the price and date are preset by both parties. 

Traded on a public exchange or clearinghouse, futures are highly regulated by relevant government agencies like the US Commodity Futures Trading Commission (CFTC). The price of the underlying asset is also established daily by the exchange until the expiry date of the contract. 

Losses and profits from futures are unlimited.

2. Forwards

These are customized contracts entered in private—without any intermediary—by both buyer and seller, where they agree to buy or sell an asset at a specific date in the future and at a price they both agree upon the date of the contract. 

However, since this is a bilaterally negotiated contract, it is less regulated. There is also a higher chance of one party defaulting on their contractual obligations called counterparty risk.  

3. Options

These are contracts that provide the right to buy or sell the underlying asset at a preset price and future date. It does not, however, oblige both parties to do so. The buyer has the call option to purchase the underlying asset, while the seller has the put option to sell it. 

An options contract, specifically equity options based on stocks, is traded in public exchanges—meaning, transactions are transparent, and there is a high level of liquidity.  

In the case of options, the losses are limited and profits are unlimited.

4. Swaps

These are derivatives that derive or base their values not on an underlying asset but instead on the cash flows of both the buyer and seller. Typically, one party pays a set rate (determined through supply and demand) while the opposite party pays a floating rate (determined by the central bank).

One basic type of swap is the interest rate swap. An example involves a swap of bonds between two parties, where the buyer and seller agree to swap their coupons or periodic interests. This agreement sets the date for the payment of these cash flows and the calculation method to be used. 

US legislations now require swaps to be traded in trading platforms called Swap Execution Facilities (SEF). This allows transactions to be more transparent and recorded.

How You Earn as an Investor
  • A derivative contract stipulates the value of the underlying asset at a preset date in the future. This value or price is called the delivery price. You can earn a profit if the delivery price is higher than the prevailing price or spot price of the underlying asset at the time the contract was made. You can earn more if the delivery price is more than the spot price at the time the contract falls due. 

Closing Notes

Financial independence is attainable. Investing in assets is one way for you to do so. There is a lot of know-how to gain and many steps to follow on the way to become a great investor. The single most important thing with investing is to start doing it. Over time, you’ll gain more experience and identify your own investment system. 

Our References and Further Readings 

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