Know the seven asset classes

What are asset classes?
In broadest term, asset classes include equities, debt/fixed income, real estate, commodities, and currency. By including different asset classes into your portfolio, you balance risk and reward as each asset class behaves differently in different market cycles.

For instance, a portfolio comprising gold and debt would have offered relatively better downside protection as compared to a predominantly equity portfolio during market crashes like 2020 pandemic and 2009 global financial crisis. Due to its safe haven status, investors rush to gold during a turmoil. This was evident in the Covid induced correction. For instance, gold prices shot up by 36% from 1500 $/t.oz in March 2020 to 2034 $/troy ounce in August 2020. (Source: Trading Economics) In CY2020, S&P BSE Sensex saw a drawdown of -38%. Thus, investors holding multiple asset classes tend to do better irrespective of the market cycle.

What are the types of asset classes?

Equities
Equities have the potential of beating inflation over long run. Over the past decade until 2024, the average inflation in India has hovered around 5.15%. The ten year rolling return of Nifty 50 during June 2004 to May 2024 stood at 12.42%, which is a return of 7% on an inflation adjusted basis. (Source: AMFI) Equities are ideal for achieving long term goals. The weightage of equity in your portfolio would depend on your risk appetite and time horizon. In addition to domestic equities, you can consider allocating to international equities which will help you get geographic and currency diversification.

Debt
Fixed income is essential for diversification as well as for providing downside protection to your portfolio. The proportion of allocation towards this asset class would differ as per your risk appetite, time horizon and goals. While fixed income securities are generally less volatile than equities, bonds have a negative corelation with interest rates – as interest rates rise bond prices fall.

Commodities
Commodities are raw materials used to produce finished products. They include agricultural products (grains, corn or soy), energy (oil, natural gas) and soft commodities (sugar, coffee). Commodities tend to have low to negative corelation to traditional asset classes such as equities and bonds. Hence, including commodities in your portfolio provides the benefit of diversification as they react differently due to changes in economy as compared to stocks. They benefit in an inflationary scenario, providing a hedge against inflation.

Cash
Cash can serve as a saviour in emergency as well as during a market correction. You should have at least one year’s of expense buffer in cash to provide for any unforeseen event. You can also park your lumpsum money in instruments such as Fixed Deposits, Liquid Funds, Ultra Short or Overnight Funds to use for tactical allocations.

Currency
Currencies are one of the highest traded assets across the world. The most commonly traded currencies in India are USDINR, GBPINR, EURINR, and JPYINR. Trading in currency involves buying and selling a currency simultaneously to profit from the changes in the underlying prices. Not all investors would understand the intricacies of these trades and one simple way to take exposure to different currencies is to invest in international fixed income and equities which helps you invest in dollar and other currencies. Investors can consider International Fund of Funds which invest in emerging and developed markets to hedge their home currency.

Real Estate
Most Indians already have exposure to real estate through their home ownership, agricultural land, plots or shops. Over the years, many innovative ways to invest in real estate have emerged. For instance, investors today have the option to invest in listed Real Estate Investment Trusts (REITs) and Real Estate Fund of Funds (FoF) which allow retail investors to invest small sums into this asset class. A Fund of Fund mobilises money from investors and invests in a fund domiciled in other country. REITs and Real Estate FoF allow investors to get exposure to a wide range of real estate assets like commercial, shopping malls, apartments, hotels, data centres, listed real estate stocks and more, not only in home country but across the globe. The main advantage of using REIT or FoF route is that investors can diversify beyond mainstream asset classes such as equity and bonds, have the benefit of liquidity without direct ownership.

Alternatives
Asset classes such as art, real estate, bitcoins, commodities, private equity, private credit, venture capital, infrastructure funds, hedge funds, among others, fall into this category. We have discussed some of these asset classes separately above. Alternative Investment Funds operating in India are registered with Securities and Exchange Board of India. They are meant for sophisticated investors who understand the risks associated with this asset class and thus come with a higher minimum investment ticket size of Rs 1 crore.

Which is the right asset class for your portfolio?
There is no straightforward answer to this question as each asset class has a unique purpose and characteristic. For instance, equities have growth potential while fixed income and cash provide downside protection. Thus, the weightage of each asset class in each investors’ portfolio would differ as per an individual’s risk appetite, goal and time horizon. For instance, if majority of your goals are long term in nature, you should ideally hold a larger proportion in equities. If capital preservation is your goal, then your portfolio should have a predominantly fixed income tilt. For achieving optimal diversification, it is advisable to include all the asset classes in your portfolio. Mutual Funds offer categories like Multi Asset Funds and Balanced Advantage Funds which provide exposure to multiple assets classes within one fund.

Conclusion
Adding different asset classes in a portfolio mitigates risk in your portfolio as each asset class may react differently under different market cycles. In technical parlance, you should aim to add asset classes that have low to negative co relation with each other. In other words, no two asset classes should move in the same direction in a given scenario.

To avoid the hassle of reshuffling your portfolio at frequent intervals, it is advisable to invest in multiple asset classes as per your goals and time horizon to protect the downside risk and optimise your portfolio for better outcome.