The Basics of Investing - What are the different asset classes?
There are several different types of assets, or asset classes.
But, for individual investors, the most important are equities and bonds, which in turn are divided into government bonds and corporate bonds.
When you buy equities — otherwise known as stocks or shares — you’re literally buying a small part of a business. You become a co-owner of that particular firm.
Your returns come in two different forms — first, any increase in the share price on the one hand, and secondly, dividends, or your share of the profits of the business.
If the firm goes bankrupt, as a share owner, you are closer to the end of the line of creditors to be repaid.
When you buy bonds, on the other hand, you’re lending money, either to a government agency or, in the case of corporate bonds, to a business.
Your returns come from interest paid on your loan.
If the business or agency defaults on its bond, you’re closer to the front of the line of creditors to be repaid with any remaining capital.
Equities are considered riskier than bonds and have generally delivered higher returns over time. This outperformance is called the equity premium.
So, although you must expect prices to be volatile at times, equities should in most cases form the largest part of a long-term investment portfolio — especially for younger investors.
That said, if you invest too much in equities you run the risk that your portfolio will fall in value far more than you feel comfortable with.
For that reason, it makes sense to dampen that risk with bonds. Generally, the older the investor, the larger the proportion of bonds they should have in their portfolio.
The third main asset class is cash.
People usually invest in cash either through savings accounts — or so-called money market funds. These are collective investment schemes which either invest your money in cash or equivalents to cash, such as short-term loans to the government.
Cash is considered to be the safest asset class of all, as it’s very unlikely — though not impossible — that you will actually lose any money.
The big downside is that over the long term cash usually delivers smaller returns than bonds — and far smaller returns than equities.
In reality, therefore, cash is for savers rather than investors.
The final asset class - usually called alternatives - principally includes property, commodities, hedge funds and private equity funds.
Some would also include in this category; art, classic cars and fine wines. All of these alternative investments are attractive in their own way, but they all have disadvantages too.
So, although you may well want to include some cash or alternative investments — or indeed both — in your portfolio, the two asset classes to focus on are equities and bonds.