The 3 Main Asset Classes
The 3 main asset classes
This article discuss the 3 most common asset classes that people invest in – stocks, bonds, and real estate.
We’ll look at the pros and cons of each asset class, what makes them so popular, as well as some potential areas to exercise caution.
Stocks
Stocks represent ownership/equity in a company that is publicly listed on a stock exchange.
The central idea of stock investing is that, by owning a small piece of companies, an investor benefits if the company prospers.
Pros of stock investing
Accessibility
Advancements in technology have made stocks perhaps the most accessible asset class in the world. With a simple brokerage app and the few clicks of a button, you can purchase shares of individual companies or funds.
Cost of entry
Relative to other asset classes, like real estate, stocks have a much lower cost-per-unit. And with many investment platforms now offering fractional share purchases, investors have a huge flexibility in their investment amounts.
These features greatly lower the entry barrier of stock investing and make it an enticing prospect for beginner investors or those who might not have much money to start with.
High potential returns
Since the performance of a stock over the long run is reflective of the success of the underlying company, stocks can potentially offer a high upside for investors.
And it doesn’t require investors to hand-pick the perfect stock either. Broad market index funds provide a low-cost, simple way for investors to essentially get the same return as the whole stock market, which has historically grown 8 to 10% annually on average.
That said, this higher return potential of course comes with a higher volatility too.
Cons of stock investing
The overconfidence trap
Though overconfidence is relevant to investing in any asset class, it’s particularly rampant in stock investing.
Perhaps this is due to how easy it is for someone with little knowledge to start buying stocks. But it’s also exacerbated by the fact that countless social media creators make it seem like the stock market is some magical money machine.
For the vast majority of investors, and certainly for beginners, the standard index fund investing approach is most appropriate.
However, people often overestimate their competence and opt to pick individual stocks that they really don’t understand that much. More often than not, losing money in the process.
Bonds
Bonds are essentially just a special type of loan, made from an investor (lender) to the bond issuer (borrower) which might be either a company or a government.
The biggest allure of bonds for the everyday investor is the prospect of low-risk, predictable returns.
Pros of bond investing
Low-risk
Though there are bonds with significant default risk (certain corporate bonds and emerging market government bonds), it’s pretty fair to say that the average investor is thinking mainly of low-risk, government bonds of developed countries (E.g., those issued by the US Treasury).
And though technically, there is no such thing is absolutely zero risk, the risk of investing in such bonds is as risk-free as one can get out of any asset class.
Predictable returns
For the typical investor who plans to hold bonds to maturity, bonds offer a predictable income distribution, in the form of bond coupons, paid out at a fixed rate and interval. This predictability makes investment and financial planning much easier.
Beginner friendly
Those just starting out investing might be uncomfortable with taking on significant risk of capital loss.
For this group of people, bond investing may provide a relatively low-risk way to ease into the feeling of investing one’s hard-earned savings.
Cons of bond investing
Opportunity Cost
Being low-risk is not without its drawbacks. The main disadvantage of bonds is that an investor can likely get higher returns over the long run from other asset classes (e.g., stocks or real estate).
Opportunity cost is the benefit the investor could have gained from choosing an alternative asset. Though bonds might be one of the safest asset classes, they don’t offer great returns over the long term. This is why you’ll rarely see investors whose portfolios consist of only low-risk bonds – because there is limited growth potential.
That said, bonds still remain a popular choice in the core of many investors’ portfolios, since they can provide some stability to balance out the volatility of other assets like stocks that the investor might own.
Real Estate
Perhaps the most timeless asset class of all, real estate is the last of the 3 major asset classes to be discussed.
Unlike stocks and bonds, which represent having an equity/debt stake in an external entity (a company or government), real estate deals with something that is physically and tangibly in the owner’s possession.
Pros of real estate investing
Innate scarcity
As the world develops and populations grow, demand for land and buildings grows. But the supply of land and the materials to build doesn’t.
When demand rises but supply doesn’t, that pushes prices up. Which is beneficial for real estate investors.
Often, people have grown accustomed to treating real estate almost as a ‘guaranteed’ return on investment, due to its innate scarcity and value. Land and property have been and still are valued highly in a world of limited resources.
Hard asset
A hard asset is a tangible, physical asset. Like a house and the land it’s built on. Compare that to something like a stock (soft asset), which represents ownership of a company.
A major implication of real estate being a hard asset is that it leveraging (using debt to buy assets) tends to be more favorable.
Lenders (like a bank) would likely be willing to finance a real estate investor’s loan request since even if the investor can’t pay back the loan, the real estate itself acts as collateral that the bank can seize and sell off to recover a significant portion of the unpaid loan amount.
In contrast, a soft asset, like stocks lacks physical presence and is also more volatile than real estate. Lenders find them less favorable collateral. If a borrower defaults (can’t pay back their loan obligation), selling the stocks as collateral might not recover as much of the loan amount.
Due to this, loans on hard assets like real estate often receive more favorable loan terms, like lower interest rates.
Cons of real estate investing
Cost of entry
The clear elephant in the room is that real estate is more expensive per unit than almost every other asset class.
For someone with only a small amount of money to invest, real estate would be far from the easiest asset class to break into.
It also means that, for beginner investors, mistakes could be costly. An ill-informed purchase could have losses at least in the tens of thousands. Compare that to stocks, where a new investor can dip their toes in the water with a few hundred dollars at a time.
Location
The reality of real estate investing is that location can affect everything. And this doesn’t just mean how many malls and amenities are nearby to drive up the market value. Location also matters in terms of what state/country you’re in.
Different places have different zoning laws, property regulations, building standards, etc. Put simply, some places simply aren’t as favorable for investment than others.