What are asset classes?

• The main asset classes are shares, property, bonds and cash.
• Assets that don't fit into these main groups are known as alternatives.
• Asset classes can be further categorised by the location of the asset, for example, Australian or overseas.
• Different asset classes have different investment return and risk characteristics.

When you invest, you are buying assets that you expect will either go up in value over time or deliver you income. These investments can be categorised into groups known as asset classes.

The main asset classes are company shares, property, bonds, cash or alternatives, which are more exotic or complex types of investments. Shares are also known as equities because when you buy a share in a company you are buying an equity interest in that company. (Incidentally, this is why it's called a share in that company.)

The value of the company shares you have invested in goes up or down depending on how profitable the  company is and the price other investors are prepared to pay to buy those shares.

Property includes real estate, which spans office buildings, retail shopping centres and industrial estates such as factories, residential property or aged care developments.

Property investments can be either the physical property (also called direct property) or shares in companies or units in funds that invest in or own property, for example, a LIC that specialises in property, or a managed fund that specialises in real estate investment, which is listed on the stockmarket - known as a real estate investment trust (REIT).

Bonds are also known as fixed interest or fixed income because when you buy a bond you are really lending money to the entity - usually a government or company - that issued that bond.

In return, the issuer agrees to pay you a fixed rate of interest over the term of the bond, which can be as short as 30 days or in perpetuity, when it has no maturity date. Sometimes the amount paid by the bond is based on a rate that varies over time, such as the cash rate. In this case the amount of the coupon will change when the underlying rate changes.

Cash can be physical in the form of notes and coins or overnight bank deposits. Its defining characteristic is that it doesn't lose capital value and is highly liquid. You have access to it pretty much any time you want.

Assets that don't fit neatly into these classes are known as alternative assets. They include more complex investments such as private equity, hedge funds and infrastructure.

Types of asset classes

Australian versus international assets

Asset classes can be further divided into other groups based on where the assets are located. This is why we refer to Australian equities, international equities and emerging markets equities, which are investments in companies in emerging growth economies, such as Brazil, Russia, India or China (a grouping known as the BRIC economies). Property can be classified in the same way.

Bonds can also be categorised according to whether the entity issuing the bond is based in Australia or in a major overseas country or emerging growth economy.

Risk and return characteristics

In addition to what assets may look like - that is, what they are physically - asset classes can also be defined according to their investment characteristics such as their likely investment return, how risky they are, how fast they are expected to increase in value and how they distribute income.

Income from different asset classes can come in the form of dividends from shares, coupons from bonds (this is the technical term for a bond's interest rate payment), the yield from cash or rent from property.

Income itself can be variable or stable. The income from shares comes in the form of a dividend payment that rises or falls depending on the underlying growth or decline of a company's profits. Income from bonds is generally stable for the life of the bond, but becomes variable (that is, may change) when the bond matures and the proceeds have to be reinvested.

The expected return from each asset class is determined by how risky it is. Investment risk comes in several forms: risk of losing money, known as capital loss; risk that income won't grow at a rate that matches inflation; or volatility risk, which is the extent to which the investment return fluctuates.

These characteristics play out differently for each asset class. For example, the price of equities can move around and sometimes goes through periods of significant capital losses.

Nevertheless, over time you should expect equities to provide higher returns than fixed interest or cash.

On the other hand, the prices of fixed income securities are relatively stable. They are relatively stable because the prices do move, particularly when interest rates go through periods of dramatic increase or decrease, but not by as much as equity prices do.

By combining different asset classes, investors or their investment managers are able to trade-off or counterbalance these returns and risk characteristics. For example, they may put equities and fixed income into the same portfolio because while their investment value (asset price) may change, they tend to move in opposite directions, meaning they insulate each other in case, say, equities have a bad year and lose value. This loss can be offset by the investment performance of the bonds.