Financial professionals constantly talk about asset classes, but what does that mean? In the broadest sense, asset classes refer to a group of securities that have similar risk/return characteristics. So, for example, in the broadest terms, stocks, bonds and cash represent the three most common asset classes. Each has different risk and return characteristics and behave differently in response to a variety of economic and political events. Stocks react most to corporate profitability, bonds to interest rates and cash to inflation. That does not mean that these are the only issues that these assets react to but they are the predominant ones.
Most managers divide these broad assets classes into subgroups that act differently at different times. Stocks, for example, can be divided into large cap, small cap, foreign or domestic. Bonds can be subdivided into government, agency, municipal, corporate, foreign or domestic. These classes can be divided again into their own subgroups. The challenge for the investor is to find ways of participating in these investments. This is where the expertise of the professional investment advisor comes into play.
Why is this important? Because investment management is often about risk control and this is often achieved by balancing various assets classes to achieve the degree of risk to which a portfolio is subjected. Modern portfolio theory demonstrates that investment with low correlation to the rest of the portfolio can lower over-all volatility even if the underlying investment itself is volatile.