In this article we will understand in detail about what is an asset class. What are the different asset classes? Why are they so important for your investment?
This article is aimed at making investors understand how they can combine the asset classes to create a winning investment portfolio.
Asset is defined by Google as- ‘a useful or valuable thing or person’. From this definition, we can conclude that anything that is useful or precious can be an Asset. All of us invest in something that is precious and that grows in value.
Continuing with our favorite example,, consider an ‘Indian Thali’ as an Investment Portfolio. The items in thali can be ‘Chapati’, ‘Sabji’, ‘Dal’, ‘Raita’, ‘Chutney’ and a ‘Sweet’. In this context, if Thali is an Investment Portfolio, then each item in the Tali is an ‘Asset Class’
Each item in the Thali provides some or the other nutrition to the body. These nutrition can be proteins, carbohydrates or fats. Similarly, each Asset Class provides some or the other ‘supplemental value’’ to the investment portfolio. While understanding each Asset Class, we shall see what are these ‘supplemental values’ in the next few paragraphs.
Broadly, Asset Classes are defined as:
- Real Estate
We shall judge each Asset Class as mentioned above on their ‘Supplemental Values’ which can be:
- Tax efficiency
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Commodity is one of the oldest asset classes. Different types of commodity as an asset class are Gold, Silver, other precious metals like bronze and brass, grains, petroleum. Though there are so many instruments in commodities, most widely used for investing are gold and silver.
The fact is that, people in India are obsessed with Gold and Silver makes it a special asset class.
How Commodity ranks on Supplemental Values:
Commodity as an asset class has a moderately low risk in terms of price volatility.
This asset class can generate moderate returns over a period of time.
Gold and Silver have very high liquidity as they can be sold at any time without any hurdles. Even if you buy Gold or Silver in the form of an ETF or Gold Fund, they can be easily liquidated.
Gold bought in any form (except for sovereign gold bonds) in India is taxed similarly. If gold is sold before 3 years the gains are added to the income of the person. If the gold is sold after 3 years, it attracts Long Term Capital Gains Tax at 20.8%. This may not be considered as very efficient taxability.
On the parameter of Ease, Gold (Commodity) scores high
Another asset class with which Indians are highly obsessed. Real estate can be a piece of land or constructed building. Real Estate is not very well regulated as an Asset Class in India. Though some regulations are enforced off late, the real estate industry is yet to see its effect.
How Real Estate ranks on Supplemental Values:
Real Estate is an asset class with moderately low risk and moderately low returns. It scores very poor in terms of liquidity as real estate is highly illiquid. In terms of tax efficiency again real estate does not do well. It attracts short term and long term capital gain tax. The rates of tax are one among the highest.
Overall, on the parameter of ease Real Estate does not score well. This is because you can not sell real estate assets as and when you want. Moreover, real estate can not be bought with a smaller amount of money.
Equity means partnering in someone else’s business by investing money. For example when we buy shares of a company, we actually invest capital in that company.
Equity is the most mis-judged asset class. There are a lot of conspiracies and mis-understanding around equity. Few extreme of them are – ‘you can get quick-rich with equities’ or ‘you will lose money overnight if invested in equities’.
I would say, if invested ‘with due diligence’ equity is one of the best asset classes to earn good returns.
Equity consists of Shares (direct equity) and Equity Oriented Mutual Funds. There are some more instruments like PMS (Portfolio Management Services) or private equity which are special equity instruments.
How Equity ranks on Supplemental Values:
Equity is a risky asset class, mainly due to volatility in price. So risk can be said to be high in equities.
We know that when the risk is high the returns are also high. Equity is a high return asset class.
One can sell shares or mutual funds at any time and cash their investments. Hence liquidity is very high in equity.
One of the lowest taxation in any investment in India is in equities. The short term capital gain tax and long term capital gain tax in equities are one of the lowest.
‘‘Overall the supplemental value of ‘Ease’ Equity scores very high.
Simply put, Debt means loan. When one person/entity gives money to use to some other person/entity on a fixed interest, it is called debt.
Debt asset class has vast instruments. Again one of the oldest classes as that of commodities. Bank Fixed Deposit (FD), Post Office Deposits, Debt Mutual Funds, Bonds, PPF, NCD (Non Convertible Debentures) are some examples of Debt.
How Debt ranks on Supplemental Values:
Risk is generally low in Debt as compared to equity. However, it can not be generalized, there are some asset classes where the risk is high.
Debt yields moderately low returns.
Liquidity is generally low as most instruments have lock-in period. However, in some cases like Debt Mutual Funds you can withdraw money any time.
You have to pay higher taxes in debt as compared to equity.
Overall, ‘ease’ is moderate in Debt.
The name itself suggests that the cash instrument is like cash. Something which can be easily liquidated.
Few cash instruments where a common investor invests are savings accounts, overnight mutual funds, liquid mutual funds. There are many more instruments where usually the institutions deal. They are Commercial Papers, Certificate of Deposit (CD), Treasury Bills etc.
How Cash ranks on Supplemental Values:
Risk is lowest in Cash as an asset class. But that is why the returns are also lowest in Cash assets. Liquidity in cash assets is very high. You can withdraw your money any time, mostly immediately. Taxation is poor in these instruments. You have to pay higher taxes as compared to equity.
Overall, ease is very high in cash instruments.
What role do the asset classes play in your investment?
An ideal investment portfolio should be a perfect blend of all the asset classes which are explained above. The % of each asset in your portfolio depends on your priorities, your risk profile, the time period available, your age and returns expected.
This is where a detailed investment planning process has to be carried out. Risk profiling is done to understand risk positioning of investors.
After this, Asset Allocation is done to decide the exact percentage of each asset in your portfolio.
For example, if the investor is in his sixties and is not positioned to take much risk, he also requires good liquidity, then the investment portfolio can be heavy on Cash and Debt assets and light on Equity and other assets.
Another example- suppose the investor is young and his goals are quite far from today, he can take some risk and desires good returns. In this case his investment portfolio will be heavy on Equity assets and light on Debt and Cash assets.
While defining the model portfolio of an investor some processes are followed and then advisors arrive at the final portfolio.