Before building an investment portfolio, it’s essential to understand its building blocks: asset classes. Understanding their differences, characteristics, and behavior can make all the difference in a long-term investment strategy.
What is an asset class?
An asset class is a group of investments that share similar characteristics, behave similarly in the markets, and are subject to the same regulations. They are the foundation of any diversification strategy.
Main asset classes and their characteristics
Below we discuss the main asset classes.
Chart taken from the book “Stock For The Long Run (6th Edition) by Jeremy J. Siegel. Final value of $1 in 2021 invested in 1802 across major asset classes (in order, stocks, bonds, bills, and gold). The chart above left shows the equivalent annualized returns (nominal, i.e. without adjusting for inflation). All data is in USD and based on the US. Therefore, figures may differ from region to region and currency. However, they are indicative of the different historical performance of each asset class.
Equity (shares):
It represents partial ownership of a company. It has high potential returns, but also high volatility. Over the long term, it tends to be the asset class with the highest real returns (8.4% APR), as seen in the chart above, and the one with the greatest potential to outperform inflation, which has historically reached a rate of 1.4% (significantly higher in recent years).
Fixed income (bonds):
They are debt instruments issued by governments or companies. They offer lower risk (volatility) and lower returns (5% APR) than equities, and can be a stable source of income. But their name is misleading. The value of bonds fluctuates, as their price is inversely related to interest rates.
Cash or money market instruments and treasury bills:
These include deposits, money market funds, and Treasury bills. They are highly liquid and low-risk, but their returns tend to be low and can be eroded by inflation. Although the CAGR on the historical chart is 4%, it has been much lower in recent years.
Real Estate and REITs:
Investing in a single property offers advantages such as leverage, but also entails high concentration and low liquidity. Alternatively, real estate funds or ETFs provide diversified exposure to the sector, combining the potential for recurring income (through dividends) and capital appreciation with greater liquidity and ease of management. Their returns and volatility are similar to those of equities.
Raw materials (gold):
This section includes all types of commodities, including oil and gold. They are often used as a hedge against inflation or economic instability. At inbestMe, we only consider gold (2.1% historical CAGR) in our ETF portfolios.
Based on these “core” asset classes, so-called permanent portfolios have been constructed.
In the table above, you can see how different asset classes behave in different economic growth and inflation scenarios. You can learn more about this topic in our post: Permanent Portfolios: The Strategy for Investing in Any Economic Condition.
Alternative investments:
They encompass strategies such as hedge funds, venture capital, and now even cryptocurrencies. Venture capital strategies tend to have lower liquidity and higher risk, but they can provide additional diversification. At inbestMe, they are only considered in Advanced portfolios.
Generally speaking, to overcome the historic 1.4% inflation rate that reduces the value of money, it is advisable to use and combine different asset classes.
And what are asset subclasses?
Within each major asset class, there are subclasses that allow for further diversification and more precise exposure adjustment. These subclasses can be divided into:
- Geographic regions: for example, US equities, Europe, Japan, emerging markets, or Asia-Pacific.
- Size or market capitalization: large-cap, mid-cap, or small-cap.
- Duration and type of fixed-income issuer: short-, medium-, or long-term bonds; government or corporate; investment-grade or high-yield.
- Type of real estate assets in REITs: residential, commercial, logistics, etc.
- Specific commodities: although inbestMe only includes gold, this class can include oil, industrial metals, agricultural products, etc.
Subclasses by investment factors
In addition to traditional segmentations, equity also includes subclasses based on investment factors. These factors are systematic characteristics that explain asset returns and allow risk modulation. The main factors are:
- Value: Companies undervalued relative to their fundamentals.
- Growth: Companies with high expected growth rates.
- Quality: Companies with high profitability, solid balance sheets, and stable earnings.
- Momentum: Companies with the best recent market performance.
- Low volatility: Companies with lower price fluctuations.
- Size: Specific exposure based on size, with mega caps and small caps being the extremes.
SRI bias or thematics can also be considered a subclass existing in the vast majority of assets.
At inbestMe, we use some of these factors (for example, we have a portfolio of value ETFs) as an option within our portfolios, which can help further diversify exposure for clients who wish to do so. We have a very broad range of SRI portfolios, which is a cross-cutting option in our offering.
Why is it important to know asset classes?
Understanding asset classes isn’t just a theoretical question: it’s key to building solid, well-diversified portfolios aligned with your goals.
One of the fundamental principles of investing is risk diversification, and to achieve this, it’s essential to combine assets that don’t move in unison. That is, they’re uncorrelated with each other. For example, when equity markets fall, fixed income or gold may perform more stably or even positively. The same is true across geographic regions or sectors.
The lower (or even negative) the degree of correlation between the assets in a portfolio, the more resilient it will be to market fluctuations.
Below is a correlation matrix between some representative asset classes:
By combining assets with different correlations, the overall volatility of a portfolio can be reduced without sacrificing profitability potential. For example, bonds have a low correlation (0.32) with US Large Cap (equities from large American companies), and gold has an even lower correlation (0.24).
This is precisely what we do at inbestMe through our diversified portfolios.
As we see in the table above, each year/period has one asset class that dominates. In 2023/2024, for example, large-cap equities. As seen on the left side, combining the different asset classes (see “Asset Allocation”) achieves a high return (7.2%) in the table, while reducing volatility (10.4%).
How do we use different asset classes at inbestMe?
At inbestMe, we select different asset classes with the goal of maximizing the diversification of each portfolio. We believe that combining assets with different performance levels allows for optimal risk/return ratios.
Depending on the client’s profile and product type, we can include equities, fixed income, REITs, commodities, or money market funds, always with a strategic and efficient approach.
Asset classes according to portfolio type in inbestMe
Conclusion
Understanding asset classes isn’t just for expert investors: it’s the first step to making informed decisions. At inbestMe, we offer a wide range of portfolios to suit your goals, leveraging the best of each asset class (and subclass) to optimize portfolio diversification.
