One of the most important decisions in investing is choosing which asset class(es) to invest in. How much you should have in each is an asset allocation decision, which is usually based on two main factors – your time horizon, and your appetite for volatility (which we discussed in our last post). We will dig into that in another post shortly, but first, let’s get to know the building blocks: equities, bonds, property, commodities, alternatives, and cash.
Equities (also called stocks and shares) is probably the first asset class that comes to mind when people think about investing, and most investors will be invested in the asset class at some stage. Essentially it represents ownership in something, such as a publicly listed company.
As with every asset class, there are pros and cons. Equities are amongst the highest returning asset classes, judged over long periods of time. However, performance can (and most likely will) fluctuate during specific periods due to company-specific reasons or macro-economic cycles, so it’s important to have time on your side with equities.
There are many ways to invest in equities. You can pick your own individual stocks or invest via a fund, ETF or an investment trust. Equity funds can be categorised by region, management style (see this post on active vs passive investing), investment philosophy (income, growth, value, etc), sector or theme. So even within the asset class itself, there is a lot of choice to satisfy investors with different goals and requirements.
Bonds is another popular asset class, usually for people who want a smoother, more predictable ride. In essence, bonds are loans to a company (public or private) or a government and the return is the interest on that loan. Bonds is considered to be a lower-risk asset class with more certainty than, for example, equities. The trade-off for this additional certainty, is lower expected returns.
But just like with equities, there is a lot of variation within the asset class. First of all, there are two main groups of bonds - those issued by companies are called corporate bonds and those issued by governments are called sovereign or government bonds.
Both types of bonds are rated by independent credit rating agencies, which decide whether the bond gets an investment-grade or high-yield rating. The rating is based on the ability and willingness of the issuer (the company or government) to repay or refinance the bond. If the issuer is a blue-chip company or well capitalised government, the bonds tend to get an investment-grade rating. Conversely, high-yield bonds are usually issued by smaller, younger and more capital-intensive companies, businesses with higher debt levels or emerging market governments and the rating is based on a higher risk of default. So, whilst bonds may have the reputation of being boring low-risk assets, there is a lot more range and complexity to be found underneath the surface.
In contrast to equities, bonds are traditionally difficult to access directly as a retail investor, though there is some innovation happening in the space to change this. But for now, if you want to invest in bonds, your best option is to do this via a bond fund.
Property, also referred to as real estate, is just what it says on the tin, except that you don’t have to buy an entire house. Instead, you can become a shareholder in different types of properties or property-related companies via a fund or a real estate investment trust (REIT).
You can invest in different types of property this way, such as commercial, residential or social housing. Many funds or trusts focus on just one type but some investment vehicles also offer exposure to other players in the property market, such as property management companies, developers, construction companies etc.
Property can be a good way to add some diversification to your portfolio and tends to be less volatile than equity markets. It is also often used as a hedge against rising inflation – as prices go up, so do house values and rents.
However, as with equities, you need time on your side to make the most of your property investments. Property is also less liquid than equities, which makes the asset class vulnerable if too many people try to sell at once. For example, due to the COVID-19 crisis, at the time of writing a significant number of property funds remain suspended while waiting for markets to stabilise.
Commodities are assets that are considered to have very little differentiation and are often used in the production of other goods and services. You can invest in anything from livestock to grains, but most investors tend to stick to just two types of commodities: oil and gold.
Commodities are usually traded on specific exchanges. As an investor, you can access the asset class through derivates or via commodity focused funds or exchange-traded funds (ETFs). If you’re new to commodity investing, a fund is by far the easiest option.
Commodities are usually used as another way to diversify your portfolio, since they have historically had negative correlation to bonds or equities. And just as property, the asset class is often used to protect from inflation. However, unlike property, commodities is a highly volatile asset class and it doesn’t produce any income, unlike bonds and (some) equities.
Alternatives is an asset class that encapsulates a number of other types of investments, from private equity to infrastructure to art and even wine!
Just like the name suggest, alternatives look beyond the more traditional asset classes and offer investors exposure to more niche assets. However, these investments need particularly long cycles for returns to really shine, so patience is advised. And like in the case of property, alternatives tend to be less liquid and harder to sell at short notice.
And last, but not least, good old pounds and pennies is a separate asset class. As we’ve explained in a previous post, cash is good for storing money you may need immediate access to in the short-term, but not so great as a long-term investment (unless you think the world is about to end).
There you have it, an introduction to asset classes. Of course, the hard work is deciding which ones are right for your portfolio, when, and in what proportion. But fear not! We will delve into that in a later post.
Date of publication: 25th July 2020
The information in this post is not financial advice, it is provided solely to help you make your own investment decisions. If you are unsure about whether an investment is appropriate for you, please seek professional financial advice. You can find more information here.
When you invest you should remember that the value of investments, and the income from them, can go down as well as up and that past performance is no guarantee of future return.