Diversifying one's investment portfolio is one of the key ways of managing risk. It's generally prudent, therefore, to diversify by stock, sector and geography. Diversifying by asset class offers a further dimension.
Diversifying one's investment portfolio is one of the key ways of managing risk – in short, it’s the practical application of the old adage: 'Don't put all your eggs in one basket'.
It's generally prudent, therefore, to diversify by stock, sector and geography. Few people would argue the merits of investing long-term in a single US technology stock for example.
Diversifying by asset class offers a further dimension. There are five 'core' asset classes:
- Equities are shares in publicly traded companies (and listed on a recognised stock exchange), or those of non-public companies (commonly referred to as 'private equity). A single share represents fractional ownership of the company in proportion to the total number of shares issued, and therefore typically entitles the shareholder to that fraction of the company's earnings.
- Bonds – a bond is essentially a form of IOU: the issuer of the bond, typically a government or company, is the borrower and the investor in the bond is the lender. In return for making the investment, the bondholder will receive interest – generally at a fixed rate throughout the pre-determined term of the bond – and the repayment of their capital at the end of that term.
- Real estate – this asset class refers to property, in the form of land and the buildings on it, along with its natural resources such as crops, minerals or water. Residential real estate refers to property intended for domestic occupation, whereas commercial property includes categories such as office buildings, retail shops and malls, factories, hotels, warehouses, hospitals, care homes and garages.
- Commodities – these are natural resources that are intrinsically valuable and/or necessary for the production of other products or services, eg gold, gas or oil. Most commodities are raw materials – that is to say, agricultural or mining products, such as iron ore, sugar, wheat or coffee.
- The final asset class is cash – which requires little in the way of explanation. Its chief advantage is that it can be accessed immediately without the need to 'trade' an asset in the marketplace.
Asset allocation can be regarded as the exercise most central to any diversification strategy, and so it's important to think about what blend of asset classes would work best for your portfolio, based on your investment objectives.