Asset classes, sometimes called asset sectors, are simply the major investment categories: stocks, bonds and money market securities. Asset allocation is the way you allocate, or invest, your dollars across the various asset classes.
Stocks, also referred to as equities, are securities that represent ownership in a company. More specifically, stock ownership is represented by shares, which you buy in order to participate in the growth of a particular company. When you own individual shares of stock, your money grows when the company grows or prospers, in two ways:
Dividends, which are the portion of the company’s profits that are paid out to stock shareholders; and
Capital appreciation, which is an increase in the value or price of shares, which means you could sell them for a profit, or capital gain.
There are two main kinds of stocks, common and preferred. A company ’s preferred stock offers a fixed dividend amount, and these dividends are paid before common stock dividends are paid. However, common stock can offer increased dividends when the company prospers, rather than the same fixed dividends. Preferred stockholders are in a better position to get their investment back if the company falters, but they also have less opportunity for growth when the company prospers.
Risks Associated with Stocks
As you might guess, you don’t just share in the success of a company when you own its stock. You also share in its setbacks. For this reason, stocks are broadly considered to be the most volatile asset class, meaning that stocks tend to experience more fluctuation in value than other types of investments, including loss of principal.
But remember that risk and reward go hand in hand. Stocks have also historically outperformed all other asset classes. For these reasons, most investment professionals feel that stocks are a strong investment option for long-term investing, but not for short-term investing. Typically, stocks are only recommended for investors whose financial objectives are at least 5 to 10 years into the future.
When companies and governments need to raise money, they issue bonds. When investors buy these bonds, what they’re really doing is loaning that company or government money for a set period of time. In return, the issuer promises a specified interest payment and prompt repayment of the loan.
Bonds are also called fixed income securities, because they produce a fixed amount of income on a regular basis.
There are many different types of bonds, each with its own risk level and reward potential. Bonds are generally categorized by type of issuer, such as corporate bonds, municipal bonds, and government bonds. (For descriptions of these kinds of bonds, see the glossary of terms.)
Corporate bonds are debt obligations, or IOUs, issued by private and public corporations. Companies use the funds they raise from selling bonds for a variety of purposes, from building facilities to purchasing equipment to expanding their business. When you buy a bond, you are lending money to the corporation that issued it. The corporation promises to return your money (also called principal) on a specified maturity date. Until that time, it also pays you a stated rate of interest, usually semiannually. The interest payments you receive from corporate bonds are taxable. Unlike stocks, bonds do not give you an ownership interest in the issuing corporation. Most corporate bonds are taxable with terms of more than one year. Corporate debt that matures in less than one year is typically called "commercial paper".
Municipal bonds (sometimes called "munis" for short) are issued by municipalities, which use the money for projects like roads, hospitals, and schools. Because these projects promote important civic development, the government can exempt municipal bond interest from taxation. As a result, many investors choose municipal bond mutual funds to earn interest that’s federally tax-free. Some municipal bond funds only invest in the bonds of a particular state, and the interest from these funds is generally free from both federal and state income taxes for residents of that state*.
Government bonds are fixed-income security instruments issued by the U.S. Treasury. Most investors regard U.S. Treasury securities as one of the safest investment vehicles in the world. This is because they’re backed by the full faith and credit of the United States government, which is considered an excellent credit risk due to the size and diverse nature of the U.S. economy and the stability of the U.S. political system.
Risks Associated with Bonds
The interest payment and the face value (the dollar amount of the bond when issued, which is also the amount to be repaid by the issuer at maturity) of a bond don’t change. However, the value of a bond relative to the market can change because interest rates affect bond prices. When interest rates rise, bond prices fall, and vice versa. So if interest rates go up, new bonds being issued will pay a better interest or "coupon" rate than the ones you may hold. Since the value of bonds can rise or fall, so too will the value of bond mutual funds that invest in them. As a result, bond funds represent moderate risk.
Money Markets **
Money market securities are very short-term debt securities, typically measured in days. Because they are so short-term, they offer reduced exposure to risk and are considered the most stable of all the major asset classes. Conversely, though, they offer limited capital appreciation potential. In fact, money market mutual funds are managed try to keep a stable $1.00 share price, while paying a low rate of return. The goal is to ensure that you can get back every dollar you put in.
Money markets are thus primarily bought for income, stability of principal and liquidity. Some money market mutual funds even offer the added benefit of checkwriting from an account.
* Income may be subject to the federal alternative minimum tax and state and local taxes.
** An investment in money market fund is neither insured nor guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although money market funds seek to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in these funds.