Part 1- Asset Classes
Taking the first step towards beginning an investment program can be intimidating. There are some basic terms and theories that you should familiarize yourself with before you make any investment decisions, like jumping into your company’s 401(k) program. We’ve outlined the most important investing concepts below, which will help you on your way towards planning for the future. Over the next two days, we’ll be talking about how different asset classes and diversification can help you shape your asset allocation.
Asset allocation is a term you’ve probably heard before, but perhaps didn’t entirely understand. So what is asset allocation exactly, and why is it important? To begin with, it is the most crucial investment decision you will make. Asset allocation refers to the percentage of assets you are going to invest across different asset categories or classes, such as stocks, bonds, and cash.
Stocks (also known as equities) represent a share or ownership interest in a company. When the company does well, you would expect the stock price to rise and you would benefit as a shareholder. Companies may pay dividends to their shareholders, either in the form of cash or more shares of stock. Similarly, if a company does poorly, you would expect the stock price to decline. In general, stocks or equities are considered investments that have both higher risk and higher return.
Bonds (also known as fixed income) represent a loan that you have made to an entity such as the U.S. Government, your local school district, or a company. Bonds typically involve interest payments from the bond issuer (one of the entities mentioned above) to you, the bondholder. When the bond matures at a set point in time, you receive back the initial principal that you loaned the issuer. Bondholders do not receive additional compensation at maturity if a company or entity does well, nor do they receive less if it does poorly. They receive a fixed schedule of payments. Bonds are generally investments that have both lower risk and lower return.
Cash and cash equivalents, like savings, money market funds or treasury bills generally are considered the safest of investments, but therefore offer the lowest return of the asset classes.
Knowing about your asset classes is the first step to determining your asset allocation. Check in tomorrow for information on how diversification helps in asset allocation decisions.