One of the most fun things about managing your own investments is coming up with an asset allocation strategy to diversify your portfolio. You get to tinker like an alchemist to find a blend of asset classes [1] that will weather the inevitable financial storms ahead – and hopefully someday leave you dancing upon the sunlit plains of financial independence.
So what asset classes make suitable straw for your passive investing [2] nest?
[3]
In this post I’ll run through the most important asset classes you need to know about as a passive investor, highlighting the pros and cons of each.
Main asset classes
The main asset classes will already be familiar to many Monevator readers, of course.
However it’s always useful to have a frame of reference – especially as the investing world can rarely agree on a single definition for anything!
Cash
Filthy lucre, spondoolicks, the root of all evil… We’re all familiar with money, though perhaps not as much as we’d like to be.
The simplicity and familiarity of cash is one of its biggest advantages, but excessive devotion to it can be the undoing of the cautious investor:
[4]
Data from JST Macrohistory [5]1 [6] and Heriot-Watt/ Institute and Faculty of Actuaries/ESCoE British Government Securities Database [7]. February 2025
Good
- You normally can’t suffer a capital loss with cash (but do pay attention to your financial protections [8] in the face of a bank failure).
- Cash is liquid [9] like water. If you lose your job and need some food or rent, your cash reserves can quickly be converted to satisfy whatever need is at hand.
- Cash typically does okay during stock market crashes. It won’t often be the best defensive asset [10]. But it’s very rarely the worst [11].
Bad
- Cash will be clobbered by inflation [12] over time. £100 will only be worth £74 in ten years, if the ongoing inflation rate matches the historical average of around 3%. Another 20 years of that and £100 will only be worth £55. (So chase decent interest rates to at least offset inflation!)
- Cash can lose value even more quickly during periods of high inflation.
- Historically, cash has earned the lowest returns of the major asset classes.
Risk/Reward trade-off
- Risk = Low
- Reward = Low
Note: the risk/reward trade-offs in this article describe the expected trade-off based upon the historical returns of each asset class. Actual risks and returns can turn out very differently.
Time horizon
Cash is useful over any time frame, but you are likely to get poor slowly if you hold excessive amounts over the long term. Spicier investment options are needed to achieve most financial goals.
More on cash
- Cash is king [13]
- Money market funds [14]
Nominal bonds
Bonds are I.O.U.s issued by an entity such as a company or government. In exchange for your loan, the bond issuer will pay you a guaranteed stream of interest over the loan period, plus you’ll get your original stake back after an agreed number of years. (Unless the issuer defaults, that is).
Passive investors should only concern themselves with investment-grade bonds, and there are strong arguments to restrict your portfolio allocation solely to high-quality government bonds. Doing so limits your exposure to the risk of default. High quality means a bond with a credit rating of AA- and above (or Aa3 in Moody’s system).
A nominal bond pays interest at a fixed rate – e.g. 2% or 3% or whatever – just like a savings account. The original loan amount (the principal) is also paid back as a fixed sum. Say £100 a bond.
This contrasts with index-linked bonds, whose equivalent cashflows are adjusted for inflation. Such inflation-linking is a highly valuable feature. We’ll come back to it in the index-linked bond section below.
[15]
Data from JST Macrohistory [5]2 [16] and FTSE Russell [17]. February 2025
Good
- Government bonds are much less volatile than equities.
- Historically they’ve provided a better long-term return than cash.
- Nominal government bonds often (but not always) rise in value when the stock market crashes. That’s the main reason ordinary investors hold them: because they help defend against terrifying falls in stock values. For example, world equities [18] lost 38% at the height of the Global Financial Crisis [19]. But a diversified portfolio split 60% equities and 40% UK government bonds, only lost 7%. That’s a much easier blow to cope with. [20]
Bad
- Bond returns historically lag equities.
- They are vulnerable to accelerating inflation and steep interest rate rises [21].
- Many investors struggle to understand bonds. Our bond terms [22] and how to read a bond webpage [23] articles will help.
Risk/Reward trade-off
- Risk = Lower than equities, higher than cash
- Reward = Lower than equities, higher than cash
Time horizon
You can duration match [24] your bond holdings to any time horizon and know exactly what your return will be, if you hold the bonds until maturity.
Sub-classes
- Government bonds (e.g. UK gilts, US Treasuries [25])
- Corporate bonds
- Inflation-protected bonds (e.g. index-linked gilts, TIPS)
- Local government bonds
- Junk bonds, i.e. high-risk bonds with terrible credit ratings
More on bonds
- Gilts explained [26]
- Best bond funds [27]
- How to choose a bond fund [28]
Equities
Equities (commonly known as stocks or shares) are historically [29] the riskiest and best rewarded of our main asset classes.
Because equities are so risky, investors demand high potential rewards to play the game. Note that word: potential. There is no guarantee that equities will deliver; they do not provide a guarantee of income or capital. Instead, they offer part-ownership of a company and thus a claim on its future earnings.
[30]
Data from JST Macrohistory [5]3 [31], The Big Bang [32]4 [33] and MSCI [34]. February 2025
Good
- Equities have traditionally outgunned every other asset class when it comes to long-term returns. They are the most powerful asset class in your diversified portfolio.
- Equities are capable of outstripping inflation. World equities have historically delivered a long-run [35]return of 6% after inflation.
- The longer you hold equities, the better your chance of achieving your financial goals.
Bad
- Severe losses can occur at any time and frequently do. You could easily lose 30% of your capital in a single year.
- Losses can be very long-lasting. The Japanese stock market crash [36] is the textbook example of a financial meltdown that took decades to recover from. The answer is to globally diversify [37].
- The highs and lows of equity ownership can feed all kinds of irrational behaviour, from panic-selling in the face of loss to piling into a bubble market. Fear and greed rule.
Risk/Reward trade-off
- Risk = Higher than bonds, commercial property, or cash
- Reward = Higher than bonds, commercial property, or cash
Time horizon
The longer you can hold the better. Five years is the bare minimum, 20 years is a more comfortable stretch.
Sub-classes
- Capitalisation (e.g. Large cap, small cap [38])
- Style (e.g. Growth [39], Value [40], multi-factor [41])
- Geography (e.g. Domestic, emerging markets [42], international)
- Sector (e.g. Technology, utilities, consumer staples)
- Themes [43]
- ESG [44]
More on equities
- Passive vs active investing [45]
- Risk versus reward [46]
- Stocks are a wild ride [47]
- Pound cost averaging [48]
Property
As an investment asset class, property (or real estate) refers to commercial property [49] that delivers returns in the shape of rent and the appreciation of building values. It doesn’t refer to your house [50].
Exposure to commercial property is generally achieved through ETFs or real-estate investment trusts (REITS).
In contrast, sticking all your money in a buy-to-let [51] concentrates rather than diversifies your holdings, and represents a big punt on the everlasting strength of the UK residential market [52].
Good
- Historically, the risk and rewards of property have been a halfway house between equities and bonds.
- It can be a useful diversifier, although global property is strongly correlated with global equities so it’s far from vital.
- Property is also likely to keep pace with [53] the rate of inflation.
Bad
- Property bubbles can pop and inflict large losses on funds.
- Property is illiquid, which can lead to certain property funds (not real-estate index trackers) imposing exit restrictions on investors during periods of market stress. In other words, they can’t sell their buildings quickly if everyone wants their money back at the double.
- UK investors tend to have a rose-tinted view [54] of property due to the strength of the home market. However the asset class has historically lagged equities.
Risk/Reward trade-off
- Risk = Higher than bonds or cash, but lower than equities
- Reward = Higher than bonds or cash, but lower than equities
Time horizon
As per equities.
More on property
- A property primer [55]
Commodities
Commodities investing [56] is tricky to understand but it can be a very useful diversifying move.
Commodities of course are the raw materials that fuel commerce: cows, wheat, oil, sugar – all that good stuff.
However there are very few opportunities for ordinary investors to bet directly on the spot market price of commodities, because not many of us can actually store several million barrels of oil.
With the exception of some precious metals like gold then, an ordinary investor’s only option is to instead invest in commodity ETFs and funds that provide exposure to the price movements of commodity future contracts5 [57].
Commodity ETFs make their money from the spot price, trading futures contracts, and earning interest on collateral. It’s best to stick to broad commodity ETFs because they diversify across many different raw materials.
[58]
Total return data from Summerhaven [59]6 [60] and Bloomberg [61]. February 2025
Good
- Low correlation with equities and nominal bonds diversifies portfolio risk [62].
- Often deliver strong returns when inflation rockets [63].
- Can perform in punishing conditions like stagflation when both nominal bonds and equities falter.
Bad
- Commodity ETFs are a volatility rollercoaster – delivering huge highs and lows that can be psychologically hard to live with.
- Bad commodity returns often show up during economic contractions when equities are under pressure. On these occasions, commodities can make portfolio returns worse at just the wrong moment.
- Not a beginner’s investment [64]. It’s best to find your investing feet with more familiar assets first and to think about commodities later.
Risk/Reward trade-off
- Risk = Approximately the same as equities
- Reward = Lower than equities, higher than bonds and cash
Time horizon
Commodities should be thought of purely as a portfolio diversifier. Their role is to pay off when equities and / or bonds are down.
Sub-classes
- Energy (e.g. oil, gas, coal)
- Agriculture (e.g. wheat, corn, rice, soybeans, cotton, sugar, coffee, cocoa)
- Industrial metals (e.g. aluminium, copper, zinc, rare earth metals)
- Livestock (e.g. live cattle, feeder cattle, lean hogs)
- Precious metals (e.g. silver, gold, platinum)
More on commodities
Gold
Gold is a commodity but it deserves its own slot on our investible asset classes list because it’s a potentially useful diversifier in its own right.
Gold is one of the simplest asset classes to understand. We all know what it is. Some of us wear it on our necks, bury it on islands, or stay up all night counting it while cackling.
The point is humans love the stuff and that’s what you’re betting on. You’re hoping that in the future someone will give you a higher price for your gold than you paid for it.
If they don’t, then you lose because gold – unlike most of the other assets on our list – doesn’t pay out any cashflow.
No interest, no dividends, no rents. Gold is just a lifeless lump of metal of limited inherent worth unless others covet it too.
[68]
Gold GBP data from The London Bullion Market Association [69] and Measuring Worth [70]. February 2025
Good
- Gold often (not always) rises in value when equities slump. That makes gold a useful counter to stock market shocks.
- Bonds and gold are complementary defensive diversifiers. That’s because they respond differently to economic conditions, meaning that gold can sometimes ride to the rescue when bonds don’t and vice versa.
- Like commodities, gold can reduce portfolio volatility because it can work when equities and bonds stumble simultaneously. This is especially useful for older investors who need to protect their nest egg against all eventualities [71].
- Shiny!
Bad
- Long-run returns are difficult to gauge because gold was price-controlled for many decades. The free market era only began in the 197os. (See the sudden price spike on the chart above.)
- There is no convincing theory that explains gold’s returns, unlike the other assets here.
- The gold price is subject to violent market mood swings. It’s highly unlikely to continue its hot streak indefinitely.
- Pirates!
Risk/Reward trade-off
- Risk = Approximately the same as equities
- Reward = Highly uncertain over the long term. Assume cash-like returns
Time horizon
Gold is highly unpredictable. Like commodities, it is probably best held in limited amounts as a portfolio diversifier.
More on gold
Index-linked bonds
Index-linked bonds are a type of government bond that protects against inflation. They do this by increasing their interest and principal payments in line with official price measures (currently RPI in the UK) to provide a reliable inflation hedge [75] when properly used.
Index-linked bonds (nicknamed ‘linkers’) typically respond like other government bonds in most situations, although there is a distinction to be drawn:
- Nominal government bonds are expected to respond more positively during ‘negative demand shocks’ when confidence crumbles, the economy contracts, and recession looms.
- Index-linked bonds are designed to thrive during ‘negative supply shocks’ when demand outstrips production and inflation takes off.
Index-linked bonds can also be expected to do reasonably well during demand-led recessions.
Good
- Specifically designed to guard your wealth from inflation.
- Ideal for dreaded stagflationary scenarios that throttle equities and nominal bonds.
- Particularly suited to retirees who are highly vulnerable to inflation wrecking their purchasing power.
Bad
- You have to use individual index-linked gilts,7 [76] held to maturity, to guarantee the inflation hedge. The only reason that’s bad is because investing in individual gilts involves quite a steep learning curve.
- Index-linked bond funds can’t be relied upon [77] to fully hedge inflation.
- UK index-linked gilt funds and ETFs are particularly unlikely to perform as expected [78] in inflationary scenarios when they’re highly exposed to interest rate risk.
Risk/Reward trade-off
- Risk = As per nominal bonds
- Reward = As per nominal bonds but potentially lower due to demand for their valuable inflation protection
Time horizon
Hold each individual linker to maturity. When they mature either spend the proceeds or invest in new index-linked bonds. Building an index-linked gilt ladder [79] is an excellent wealth preservation technique for retirees.
More on index-linked gilts
- How to buy individual index-linked gilts
- Index-linked gilts: how to price, value, and track [80] them
- Who needs index-linked gilts? [81]
Other asset classes
You’ll no doubt have heard tales of the killings to be made in:
- Hedge funds
- Private equity
- Currencies
- Crypto
- Volatility (e.g. the ‘Fear index’)
- Collectibles (e.g. art, wine, cars)
A passive investor wades into these waters at their peril. Most alternative asset classes can be discounted on some or all of the following grounds:
- Their role in a diversified portfolio is highly questionable.
- They suffer from high costs, or illiquidity, or other barriers to entry/exit.
- Information asymmetry is high. A high degree of expertise is required to avoid being spanked by other players in the market.
- Their track record is extremely difficult to independently verify.
The bottom line is that any investor can construct a diversified [82] portfolio from the main asset classes: cash, bonds, equities, and gold.
More experienced investors who are vulnerable to inflation should consider adding index-linked bonds and commodities.
Take it steady,
The Accumulator
- Òscar Jordà, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick, and Alan M. Taylor. 2019. “The Rate of Return on Everything, 1870–2015.” Quarterly Journal of Economics, 134(3), 1225-1298. [↩ [87]]
- Òscar Jordà, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick, and Alan M. Taylor. 2019. “The Rate of Return on Everything, 1870–2015.” Quarterly Journal of Economics, 134(3), 1225-1298. [↩ [88]]
- Òscar Jordà, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick, and Alan M. Taylor. 2019. “The Rate of Return on Everything, 1870–2015.” Quarterly Journal of Economics, 134(3), 1225-1298. [↩ [89]]
- Dmitry Kuvshinov and Kaspar Zimmermann. 2021. The Big Bang: Stock Market Capitalization in the Long Run. Journal of Financial Economics, Forthcoming. [↩ [90]]
- An agreement to buy or sell a commodity at a particular price, at a set date in the future. [↩ [91]]
- Bhardwaj, Geetesh and Janardanan, Rajkumar and Rouwenhorst, K. Geert, “The First Commodity Futures Index of 1933,” Journal of Commodity Markets, 2020. [↩ [92]]
- UK Government index-linked bonds. [↩ [93]]