Finally it has dawned upon you that retirement and cessation of income is a reality and you need to invest for the golden years of life.
However, even before you rush to a financial planner, it is critically important to understand where your hard earned money will be invested and in what asset classes. And considering the number of financial products available out there in the market, understanding asset classes becomes even more vital.
How do we Define Asset Class?
An asset class can be defined as different type of financial instruments or products that share few characteristics, tend to behave in a similar way under certain market conditions and more or less are governed by same set of laws. For instance, equities and mutual funds are highly susceptible to market conditions and it is quite possible to lose your entire investment.
Conversely, if managed properly these same financial instruments can yield high returns and multiply your investment numerous times. In essence, though equities and mutual funds are entirely different financial products, they behave in a similar way in market, are guided by similar risk-reward ratio and are governed by more or less same set of laws.
Though there is not universal list of different asset classes, they can be put into five different kinds that are widely accepted:
- Fixed income
- Cash
- Real estate
- Equity
- Commodities
Fixed Income
As the name suggests, this vanilla asset class is one of the safest investment instruments that if invested for a pre-defined period, yields a fixed income while ensuring that the principal investment also stays safe.
Certificate of Deposits, government issued bonds and securities, corporate issued securities, inflation protected securities, mortgage backed securities, and asset backed securities are some of the fixed income asset class financial instruments. Income yield from fixed income asset classes can be taxed depending on the period of investment and type of instrument.
Cash
Apart from the greenbacks stashed under your mattress, cash asset class instruments are exactly what they imply – they can be liquidated easily enabling you to have cold hard cash in your hands. Like the fixed income asset class of financial products, these too are low risk and low income investment vehicles with assurance of capital protection.
Treasury bills, commercial papers, marketable securities, money market funds, and short-terms government bonds are different kind of financial products under this class. The biggest drawback of this asset class is either moves in tandem with inflation or gets beaten by it, thus returning zero yield in the long term.
Equity
The darling of Wall Street but not on main street and the reason why the Oracle of Omaha Warren Buffet (thoughaccording to many his knowledge on how an economy creates jobs is anemic while his knowledge on how to create wealth for himself is awesome) is one of the richest persons in the world – equities. These financial instruments are traded among investors as ownership of the business imparting you certain rights similar to that of the owners, like a share in the profits, bonuses, and voting during board member elections.
Mutual funds, which again have equities as an underlying class are susceptible to market conditions as equities. These high-risk and high-return investments is one the most utilized asses classes the world over. There however are no assurances on returns and neither on the capital. Income generated through equities can be tax free if held for the long term.
Real Estate
This asset class requires no real explanation. Any immovable property, either residential or commercial comes under this class. However, unlike other asset classes, a significant amount of upfront cash is needed to invest in real estate. Mortgaged real estate cannot really be termed as an investment as you are already paying money to a financial company in equal monthly installments for lending you the cash to procure the real estate.
Income from real estate again has no assurances, which usually is in the form of rental income. You however need to spenda significant amount of money every year in the form of taxes and maintenance costs, which can offset your rental income. Flipping is a popular form of generating income in the real estate category, but is fraught with complexities and risks. Capital gains from real estate income is taxable.
Commodities
Any type of raw material needed for producing anything comes under the commodity asset class. For instance, agricultural such as corn, wheat, rice, and so forth is a commodity. Likewise, gold, silver, copper, aluminum, and crude oil is also a commodity. However, contrary to some perceptions, commodities are not really the best avenues for investing, but better for trading since you can buy and sell the commodity during its price movements.
Gold which is a commodity and also a traditionally perceived safe haven for investors is just a hedging tool rather than an investment. Income generated through commodity trading is taxable.
Where to Invest?
The answer to this question is very subjective and largely depends on your investment goals, risk appetite, and most importantly, your understanding of different asset classes. Continually keeping yourself updated about market movements can help you in this regard. Happy investing!