For many people, the world of investing is mysterious, with unfamiliar terms and concepts. The good news is that successful investing doesn’t require advanced math skills or complex strategies. Instead, it starts with understanding the basic building blocks of investing—known as asset classes—and how they fit together. From the relative safety of a savings account to the growth potential of stocks, each type has different potential for risk and rewards.
Understanding where these different assets stand on the investment risk ladder can give you a solid foundation for getting started in investing.
Fast Review
Every investment sits somewhere on the risk ladder, with cash being the safest but lowest-returning option and alternative investments typically being the riskiest but with the potential for the highest returns.
Sticking with index funds or exchange-traded funds (ETFs) that mirror the market is often the best path for a newer investor.
The stock market has historically delivered higher returns than bonds over long periods, but it has had greater short-term risks and far wider price swings.
Investment experts recommend spreading money across different types of investments (diversification) rather than putting everything into one category.
For many people, the world of investing is mysterious, with unfamiliar terms and concepts. The good news is that successful investing doesn’t require advanced math skills or complex strategies. Instead, it starts with understanding the basic building blocks of investing—known as asset classes—and how they fit together. From the relative safety of a savings account to the growth potential of stocks, each type has different potential for risk and rewards.
Understanding where these different assets stand on the investment risk ladder can give you a solid foundation for getting started in investing.
Understanding the Investment Risk Ladder : How to Invest with Confidence
Here are the major asset classes, in order of ascending risk, on the investment risk ladder:
Cash
A bank deposit is the safest and easiest investment asset to understand—it’s also usually the first one we have. It not only gives investors a detailed account of the interest that they’ll earn but also guarantees that they’ll get their capital back. On the downside, the interest earned from cash socked away in a savings account seldom beats inflation.
Certificates of deposit (CDs) are less liquid, generally offering higher interest rates than savings accounts.1 Money is locked in a CD for months to years. You usually pay a penalty if you withdraw it earlier.2
U.S. Securities and Exchange Commission. “Certificates of Deposit (CDs).”
Read More: Money Market Accounts vs CDs: Which Investment Is Better?
Bonds
AÂ bond is a loan made to the issuer by an investor. A typical bond involves a corporation or government, where the borrower will issue a fixed interest rate to the buyer of the bond in exchange for using their capital. U.S. Treasuries are the most popular bonds in the world.
Read more: Investing in Savings Bonds
Bond rates are essentially determined by central bank interest rates.4 That’s why they’re heavily traded when the U.S. Federal Reserve—or other central banks—raise rates.
Mutual Funds
A mutual fund is a big investment pool where many people put their money together and hand it to a professional money manager who buys stocks, bonds, or other investments on their behalf. In return, you get shares proportional to how much you put in for the immense pool of assets.
These funds take investors with as little as $500 to start, and many have no minimum. Even with a modest investment, you can own pieces of hundreds of different companies. For example, if you invest $1,000 in a mutual fund with 100 different stocks, it’s like buying small slices of all those companies simultaneously.
Some mutual funds mimic popular indexes like the S&P 500, which is what the first mutual funds in the 1970s did. These are called “passive” funds since the managers just want to match a specific index, which takes far less effort than trying to beat the market.
Other mutual funds are actively managed, meaning investment professionals try to beat the market by constantly adjusting their investments (like a chef experimenting with ingredients). These funds typically charge higher fees, which can eat into your returns over time.
Exchange-Traded Funds (ETFs)
Exchange-traded funds (ETFs)Â became highly popular since they were launched in the early 1990s. ETFs are like mutual funds but trade throughout the day on an exchange. So, you can trade them just like shares of Apple (AAPL) or another publicly traded company. Their value rises and falls as the trading day goes on.
ETFs can mirror an underlying index, such as the Dow Jones Industrial Average (DJIA), or other baskets of stocks that an ETF manager chooses. The index might cover anything from emerging markets to commodities, business sectors like biotechnology or agriculture, and more, though the most popular, for large institutional investors and those putting a bit into a fund each paycheck, remains those that track indexes.
Stocks
When you buy a stock, you’re buying a tiny piece of ownership in a company. If you own Apple stock, for example, you really are a part-owner of the company—even if it’s just a modest amount.
There are two main ways to make money from stocks:
- The share price goes up after you buy it: First, when other investors like what they see with the company and like the price offered to buy shares, they’ll buy the stock. If enough people do this, the share price will go up. When it does, you can sell your shares—the amount above what you paid for them is called price appreciation—to net a capital gain.
- Dividends: These are regular payments that represent profits shared by companies with their stockholders. Companies that have provided dividends for 25 straight years are known as dividend aristocrats.
However, stocks come with real risks. Companies can lose money, stock prices can fall below what you paid, and in the worst case—if a company goes bankrupt—stockholders are last in line to get any money back. That’s why financial advisors often suggest not investing money in stocks that you’ll need within the next five years.
But you can lower your risk by choosing certain types of stocks. Large, established companies like Coca-Cola (KO) or Johnson & Johnson (JNJ) typically offer more stable but slower growth. Midsized companies offer a middle ground, while small companies, called small-caps, can grow explosively but are also more likely to stumble.
The riskiest stocks often come from young companies in emerging industries or those in financial trouble. Nicknamed “penny stocks,” they trade for less than $5 per share
Read more: Guide to Sustainable Investing: Profiting Ethically
Comparison Summary
Feature | Cash | Bonds | Stocks |
Primary Goal | Capital Preservation | Income/Stability | Growth/Wealth |
Liquidity | Highest; easily accessible | Moderate; traded on markets | High; traded throughout the day |
Inflation Protection | Poor; rarely beats inflation | Moderate; some adjust for it | Good; values often rise over time |
Risk of Loss | Near Zero (if insured) | Low to Moderate | High; can lose total value |
Alternative Investments
There is a vast universe of so-called alternative investments that aren’t stocks, bonds, or funds that collect them:
- Real estate: You can invest in property in two ways. The direct approach involves buying buildings or land, which requires considerable effort and significant capital. But it’s easier to buy real estate investment trust (REIT) shares. These are companies that own and manage properties. REITs trade like stocks but must pay out 90% of their profits each year to investors, resulting in higher dividends.16
- Hedge funds and private equity: Called accredited investors, these investment vehicles are like exclusive clubs, so they’re only open to those who already have wealth. Hedge funds use complex strategies to try to make money whether markets go up or down. Private equity firms buy entire companies, change their structure, and sell them for a profit. Both usually require investors to lock up their money for years.1715
- Commodities: These are physical goods like gold, crude oil, or agricultural products. You can invest in commodities through special funds that track their prices. Many investors use commodities to hedge against inflation since their prices often rise when the cost of living increases.18 Some specialized ETFs are also designed to focus on commodities.
 Read More: What Is ESG (Sustainable) Investing? Complete Guide
What Are the Different Asset Classes?
Historically, the three main asset classes were equities (stocks), debt (bonds), and money market instruments. Today, you’d add real estate, commodities, futures, options, and even cryptocurrencies as separate asset classes.
Which Asset Classes Are the Hardest to Trade?
Generally, land and real estate are considered among the least liquid assets since buying or selling a property at market price often takes a long time. Conversely, money market instruments are the most liquid because they can easily be sold for their full value.
What Asset Classes Are Best When Inflation Is High?
Real estate and commodities are considered good inflation hedges because their value tends to rise as prices increase. Additionally, some government bonds adjust automatically for inflation, making them an attractive way to store excess cash.
