Key takeaways

By spreading investments across various asset classes -- such as equities, fixed income, cash, real estate and alternatives -- investors can minimize their portfolio's volatility.

Risk and reward vary by asset class.

Choosing the best asset mix depends on factors like an investor's age, investment goals and risk tolerance.

Asset classes are groups of similar investments that might be subject to the same market forces, laws and regulations. For investors, understanding asset classes is important because each asset class has varying levels of risk and reward. Investors can construct a more balanced and less risky portfolio if they use asset allocation to spread their investment across multiple asset classes.

Stocks, bonds and cash are some of the most prominent asset classes, but some investors opt for a few others to help round out a portfolio so it's less correlated with the overall market.

What is an asset class?

An asset class is a group of similar investments that typically operate according to similar principles. For example, many of the largest companies issue shares of stock, also called equity, which confers certain rights of ownership. In contrast, bonds are issued by corporations or governments and are known as fixed-income assets and provide certain payments. These asset classes, in addition to cash, form the most well-known groups of assets.

Types of asset classes

The asset classes below form some of the most important types for investors to know.

Cash and cash equivalents

Cash is how most people get paid and what we often use to make purchases, so it's a highly liquid asset. It might include either U.S. dollars or currency from another country (or region, in the case of the euro). In contrast, cash equivalents are assets one can easily convert to cash.

Both asset types usually have very low risk but low growth potential and are especially subject to inflation because of their low returns. Examples include money market accounts, savings accounts and cash itself.

Equities

Equities include shares of stock in companies, which may include publicly traded companies or private companies, and they represent ownership stakes in those businesses. These assets may have growth potential but can be more volatile than other types of assets. Stock prices can change based on company performance, investor sentiment and economic conditions.

Equities include both common and preferred stock. Buying equities through a stock mutual fund or exchange-traded fund (ETF) can allow you to create a diversified portfolio quickly and easily. Stocks have some of the most attractive long-term returns among major asset classes.

Fixed income

Fixed income is a type of asset that investors buy in exchange for interest payments over time. Fixed-income assets tend to fall between equities and cash in terms of risk and growth potential. However, both fixed income's risk and reward potential tend to be low. The asset class of fixed income includes assets such as bonds, annuities and CDs.

Real estate

Real estate can include many types of real property, including residential real estate (as either a primary residence or investment property), commercial real estate and real estate investment trusts (REITs). Real estate tends to appreciate slowly, and this asset class might perform well in inflationary climates that may be more difficult for other asset classes.

Precious metals

Precious metals may make good countercyclical investments and include well-known options such as gold, silver and many others. Precious metals might perform well in economic climates that are unfavorable to other asset classes.

Alternative investments

Alternative investments are investments that fall outside of the other, more traditional asset classes such as private equity or hedge funds. In some cases, they can be newer assets, such as cryptocurrency (though many well-known investors strongly resist crypto as an asset class).

Part of the appeal of alternative investments is that they may be less correlated to public investments, offering some diversification for investors. But alternative investments may also allow access to attractive investments that are otherwise off-limits to most investors.

Which asset class is the riskiest and which is the safest?

Traditionally, equities have been considered among the riskiest investments, while cash and cash equivalents have been considered the safest. However, there can be exceptions in either case. Cash can be unusually risky at times, such as when inflation is soaring, and some stocks are safer than others, though stocks are all generally hurt by rising interest rates.

But given the dangers of inflation, cash is not a great investment, while a broadly diversified portfolio of stocks has helped investors maintain their purchasing power.

The fact that we cannot speak in absolutes is exactly why diversifying is essential. Spreading your portfolio across multiple assets and asset classes -- called asset allocation -- will help your portfolio perform better while avoiding some unwelcome surprises. Although you can't plan for everything, building a portfolio that reduces your exposure to unnecessary risk is possible.

How to diversify your portfolio using asset classes

Spreading your investments across asset classes is beneficial because each asset will tend to have a different level of risk and growth potential. So a diversified collection of assets reduces the volatility of your portfolio. In other words, one asset might do well while another one struggles and vice versa, reducing fluctuations in the overall portfolio.

There is no best way to diversify across asset classes because each investor has different goals and expectations. For instance, most financial advisors say that younger investors should have a high allocation to equities, while older investors should reduce their equity exposure in favor of lower-risk fixed income. This is because younger investors might have many years to make it through economic downturns and stock fluctuations, while older investors might not.

Individual investors also have different levels of risk tolerance, but portfolios could generally be broken down into three broad categories: aggressive, moderate and conservative. For example, you could diversify your portfolio using more than just stocks and bonds, as follows:

Aggressive: 80 percent equities, 10 percent bonds, 5 percent real estate, 5 percent gold

Moderate: 70 percent equities, 20 percent bonds, 5 percent real estate, 5 percent gold

Conservative: 60 percent equities, 26 percent bonds, 7 percent real estate, 7 percent gold

Some investors might prefer holding cash instead of gold. So an alternative portfolio could consist of 82.5 percent equities, 7.5 percent REITs and 10 percent fixed income/cash. There is no limit to the number of ways you might decide to diversify across asset classes, depending on your needs, risk tolerance and time horizon.

These examples illustrate the strategy of diversifying your portfolio with different types of assets and how that might change. In general, conservative portfolios reduce their allocation to equities or other risky assets. They then move that money to more conservative investments, such as fixed-income assets and cash or cash equivalents.

Bottom line

Investors should understand what asset classes are and how certain types of investments might respond similarly to the economic climate. This knowledge can help them construct portfolios that are more diversified, less risky and less correlated with the broader market.

-- Kim Husband contributed to an update of this article.