Asset Class Investing
Some advisors refer to investment categories, such as stocks and bonds, as asset classes. An asset class is a group of securities that has common risk, performance, and financial characteristics. For example: Common stocks of domestic companies are lumped into a major asset class. Then the class is broken into smaller categories based on capitalization (price x outstanding shares), dividend payment rates, and other financial criteria.
Risk Management
You might invest all of your assets in one asset class if you knew, with a high degree of certainty, that asset class will perform the best in the future. Speculators might put all of their eggs in one basket. Most investors put their eggs in multiple baskets to hedge their risk of being wrong. For example:
- High Risk: You invest 100% of your assets in small capitalization growth stocks and the category suffers severe investment losses. 100% of your assets are impacted by the loss
- Reduced Risk: You invest 10% of your assets in small capitalization growth stocks so 10% of your assets are impacted by the loss
Future Performance
Think of an asset class as a basket of securities. You win if you invest your assets in the right baskets. You lose if you select the wrong baskets. You invest in several baskets (see diversification) because you cannot predict the future performance of particular asset classes. This one investment decision may have more impact on your future performance than any other decision.
Paladin says.....
Select assets classes that have different performance and risk characteristics. For example, inflation may cause stocks to decrease in value and real estate equity to increase in value. The offsetting performance of stocks and real estate will reduce your financial risk of large losses.