How to Select the Right Investment Asset for Your Portfolio
Investment assets are items that you purchase in the hopes that the items will increase in value. Stocks, bonds, and cash are a few common examples of investment assets.
Part of the challenge of investing is deciding what assets to invest in. To achieve a balance of risk and reward that matches your comfort level, you need to review the pros and cons of each option.
Most Common Types of Investment Assets
Asset classes are groupings of investments with similar regulations and characteristics. Traditionally, investors divide assets into three main classes:
These classes also include additional categories, such as mutual funds, 401(k)s, index funds, and ETFs. Financial advisors and portfolio managers refer to these categories as investment vehicles.
The asset classes typically provide different levels of risk and return in varying market environments. Investors wanting to minimize risk and maximize return often use asset diversification.
Here is a closer look at each of these asset classes to help you understand the potential risk and return.
Bonds (Fixed Income)
Bonds typically pay a set interest rate over a specific period. This offers more stability compared to stocks. These are lending investments where you issue a loan to a company or the government.
The value fluctuates based on the current interest rates and the rate of inflation, but offers a guaranteed payment in a fixed time period. Due to these features, investors also refer to bonds as fixed income.
Some investors add real estate to the same category as bonds. Both options provide regular income.
With bonds, the company or government repays its debt with added interest. The guaranteed interest is fixed income. With real estate investments, you gain a fixed income from the monthly rate.
Fixed income is any type of investment where the borrower agrees to make payments on a fixed schedule with a fixed interest rate.
This asset class includes low to moderate risk with moderate returns, depending on the specific investment vehicle.
Pros and Cons of Investing in Bonds
Bonds provide greater stability compared to high-risk assets. When you purchase a government bond or a corporate bond, you can expect to receive specific gains that you can calculate immediately.
The returns for bonds are almost guaranteed. The biggest risks include missed opportunities and limited liquidity.
As interest rates fluctuate over time, the rates may increase after you purchase a bond. You then miss out on receiving a fixed return based on the higher interest rates.
Bonds also have limited liquidity, as the maturation date of the bond remains fixed. You typically receive a penalty for liquidating the bond early.
With these features, bonds and other fixed-income assets provide suitable options for long-term investing with low to moderate risk.
Stocks represent shares in publicly held companies. The stock markets offer the most volatile environment for short-term investing. However, equities and stocks also offer a higher potential gain.
Overall, investing in stocks tends to provide reliable high returns over a longer period. When you have a longer time horizon before your retirement, a higher ratio of stocks in your portfolio makes sense.
As you get closer to retirement, you may want to rely more on a fixed income and begin limiting the high-risk assets.
Multiple investment vehicles exist for investing in stocks. You can purchase individual stocks or invest in stock mutual funds.
Stock mutual funds are a type of exchange-traded fund that tracks an index, such as the S&P 500. Purchasing several funds allows you to easily diversify your portfolio and limit your risk.
Pros and Cons of Investing in Stocks
The main advantage of investing in stocks is the potential for a greater return on investment, especially when investing in a hedge fund or selecting individual stocks.
The drawback is the risk for financial losses. If the index performs poorly, the value of the stock mutual fund drops. Fluctuations in the market can send novice investors scrambling, increasing the risk of greater losses.
For most investors, stocks offer a necessary foundation for long-term financial planning. If the level of risk scares you, consider investing in a stock mutual fund or a standard mutual fund.
Cash and Cash Equivalents
Examples of cash equivalents include treasury bills and money market funds. With treasury bills, you essentially loan money to the government and redeem the bill for returns based on the inflation in value.
Money market funds work like savings accounts with higher interest rates for those with significant deposits. Regular savings accounts are also a type of investment, but with limited returns.
Certificates of deposit (CDs) are also cash equivalents with guaranteed income. You deposit money for a specific period with a higher fixed interest rate compared to a standard savings account.
Pros and Cons of Cash Equivalents
The most stable investments include cash and cash equivalents. These options offer a very limited return on investment, but provide very low risk and access to funds quickly.
Along with the traditional asset classes, many investors now include real estate as its own class. Real estate investments include real estate investment trusts (REITs), real estate mutual funds, wholesaling, partnerships, and real estate service companies.
Conclusion – What Assets Should You Choose?
The potential risk, return rate, and time horizon are a few of the main considerations for choosing the right assets.
Investors often discuss risk tolerance. This is the level of loss you are willing to withstand. With high-risk investments, you may need to deal with large changes in the value of your assets.
Instead of riding out a sudden drop in value, you may panic and withdraw your investment too early, resulting in a loss or limited return.
You should also analyze the potential return. With fixed-income assets, such as bonds, you can calculate the return based on the fixed interest rate. With CDs and cash equivalents, you can expect a limited return with a bit less risk.
Stocks tend to offer the highest potential return with the greatest volatility, especially for short-term investing.
If you struggle to choose an asset that matches your specific goals, consider working with an investment firm or a professional portfolio manager. These financial experts can help select assets based on your risk tolerance and time horizon.