A bedrock of investing, asset classes are groupings of investments that have similar financial characteristics. Each asset class carries its own set of risks and rewards. There will usually be little correlation between asset classes; when a specific asset class is performing well, others may lag or underperform. Owning investments from different asset classes, known as diversification, can help reduce the overall volatility experienced by a portfolio. Investors’ investment goals, like their personal circumstances, differ and so asset class weightings will vary.
Shares (equities, stocks)
If you own shares in a publicly listed company, you own a small part of that company. Listed on stock markets, share prices move up and down depending on investor supply and demand. Investors can make money from their shares mainly in two ways:
when the company pays out some of its profits to shareholders via a dividend, either in the form of cash, additional shares, or both
by selling their holdings on the stock markets for more than they paid.
An attractive feature of many shares is that they are easy to buy and sell (‘liquid’). However, they can also be volatile, meaning the price can quickly move higher or lower. Examples of this might include a company being taken over at a premium or sold down if it reports disappointing results. Among traditional assets, shares have historically delivered the best long term investment returns.
Low liquidity risk
Affected by market risks
Bonds (fixed income)
Bonds, also known as fixed income because they pay a fixed interest rate to investors/creditors, are an ‘IOU’ by an issuer who will make cash payments to investors on a regular basis.
Governments and companies are the largest issuers of bonds. They can be issued for a wide range of time scales before maturing – anything up to a couple of years is being short term, between two and ten years regarded as medium term and between ten and thirty years is viewed as long term. Bond issuers will usually pay a higher rate of interest on a long term bond. In addition to the regular interest payments investors receive, at maturity (i.e. when the bond is repaid) the original amount the bond holders invested will also be returned.
Bonds are not risk free. Credit risk, also known as default risk, is the danger that the bond issuer, either a government or a company, could default on its coupon payments (so-called because historically bonds existed in physical form and were issued with ‘coupons’ attached to them) or the repayment of the original amount. The risk profile of the government or company issuing the bonds informs the level of interest paid (eg. a higher level of interest paid to compensate for a higher risk profile).
Lower market risk
Affected by credit risks
Real estate (property)
Dominated by residential property, this is the world’s oldest and largest asset class with a total value estimated recently as more than the combined value of all global equities and debt securities.
Investors can act directly as landlords, earning a return by charging rent on commercial and residential properties. They can also invest indirectly, owning a share in a portfolio of real estate through a real estate investment trust (REIT). Traded on stock exchanges, REITs can be bought and sold like any shares. Both direct and indirect investors in real estate will benefit should the property rise in value and be sold at a premium.
Investors may find property an appealing option as it gives them the chance to buy something tangible. Real estate also has a low and sometimes negative correlation with other major asset classes, making it an attractive choice of asset for its diversification benefits.
However, it can be difficult to sell in a crisis, meaning investors may be unable to get their money back when they want it or they might be forced to accept a lower valuation. This ‘liquidity risk’ is the main reason it should be considered a long term investment.
Lower market risk
Affected by liquidity risks
An alternative investment is the umbrella classification for a broad range of assets that do not fall into one of the other conventional investment categories (incl. stocks, bonds and cash). Alternative investments often have low correlations with these traditional asset classes.
Examples of alternatives include infrastructure investing, private equity, commodities and collectibles. Real estate is viewed by some investors as an alternative investment, while crypto-currency is a relatively recent addition to this asset class.
Alternatives are often favoured by institutional investors and high net worth clients, attracted by the potential for outsized returns and because of their diversification benefits. Commodities, for example, may be considered effective hedges against inflation. Yet depending on the instrument to be invested in, alternatives can be complex, risky and provide less liquidity compared with traditional assets. This means that investors may find them difficult to sell should cash be required quickly. A lack of regulation and transparency may be further concerns depending on the specific asset.
Can reduce inflation risk
Affected by liquidity risks
Cash is generally regarded as being the safest place to keep your wealth, which is why it is often a great place to park short-term money (in nominal terms, one dollar will always be one dollar). Cash refers to physical currency, the balances of savings and current accounts, tax-efficient wrappers and money market funds. Risk averse investors favour cash for its two key attributes:
Liquidity: instantly available, cash held during a market downturn could allow investors to purchase undervalued assets at a discount.
Stability: Other assets such as shares and bonds may also be easily tradable but variable pricing makes these more volatile. Another feature of cash is that its returns tend not to be correlated with other assets, making it a potentially important tool for diversification.
The downside of cash is that inflation can chip away at the real value in an investor’s pocket. Over time, those who only hold cash can see the real value of their savings fall. That’s why it should be considered as part of a diversified investment strategy.
Low market risk
Affected by inflation risks
Starter Guide to investing
When you’re new to investing, getting started can seem like an uphill struggle. That’s why we decided to create a starter pack to help demystify the process and provide an introduction to the basics.