Whenever you buy a financial product or deposit funds into a pension scheme, you invest in assets, which are grouped into ‘classes’ or categories.
Asset classes are important because, even though the exact nature of an asset within the same category might differ from another, it will carry similar risk exposure and be subject to comparable regulations and laws.
Understanding asset classes and the pros and cons can help diversify your portfolio and ensure a certain degree of defence against potential market downturns that will only affect one element of your invested wealth.
Further reading on this topic is available through our previous guide to Investment Diversification.
The Main Asset Classes to Be Aware Of
There are three core asset classes:
- Equities – stocks
- Bonds – fixed-income products
- Cash assets – money or market instruments
We could also add property and commodities to that list, where investing in real estate, energy, metals, or oil may carry a different risk profile.
Each asset class presents a different opportunity in terms of exposure to market changes, potential gains and losses, assessed risk and average returns, which we will summarise below.
Newer investors tend to assume that shares or equity assets are the only types of investment – but they form one element of a well-managed portfolio.
Shares are issued by public companies and traded on stock markets where ownership of each share gives you equity rights and shareholder status. However, you are unlikely to be given influential voting capacity or a say in the business unless your shareholding is large.
Shareholders can attend the company AGM and vote on proposed resolutions, usually with one equity share representing one vote, depending on the shareholding structure.
Investors can achieve a return on equity assets through the following:
- Capital growth: the share price rises, meaning that your equity assets are now worth more and can be sold on the stock market if you wish.
- Dividends: companies pay proportionate dividends to shareholders when making a profit, typically bi-annually.
There isn’t any guaranteed dividend, and companies may reinvest profits into the business. Likewise, share prices can fall as well as grow, so the full value of your investment is subject to risk.
Historically, equities have outperformed other asset classes, but it is important to be mindful that this doesn’t assure profitable returns in the future.
Equity shares are also the most volatile over the short term. Capital growth and returns can fluctuate depending on multiple variables such as company restructures, market share and the overall business climate.
Bonds and Fixed Income Assets
Fixed income bonds pay out a predetermined interest value over time, or when the bond matures, with more stability than equity assets, and set interest rates.
Even though the bond itself might return a static amount, the value of the investment can vary with inflation and interest rates.
Buying a bond means you are effectively lending money to the issuer, which could be:
- A corporation
- A government body
- Another entity
Bonds that pay out regular income, or coupons, provide a confirmed pay-out, returning the bond’s value to the investor before the maturity date.
An important consideration is that the bond only provides capital growth if it was bought at a below-par price – capital is unlikely to be repaid in full if you invest in a bond at a point where the market value is higher than the real valuation.
The benefit of fixed-income assets is that the risk is generally lower, although the anticipated returns are also lower than for equities.
If the bond issuer cannot fulfil their commitment to pay coupons or repay the bond value, they fall into default – this situation is rare but not impossible. Hence, bonds are low risk but not without any risk at all.
Money Market Investments
Cash is another asset class often misunderstood. Money market products are more liquid and short-term than most other investments, including government-backed securities and Certificates of Deposit.
There is less growth potential but equally less volatility. Investors can buy into a cash fund that invests in a range of short-term securities, cash and money markets and usually achieve better returns than they would through a conventional deposit account.
Investing in capital markets is not without risk because investment values and returns can go up and down, and there isn’t any guarantee that you will recover the originally invested amount.
Cash assets are, however, generally seen as low risk, with lower comparable returns than equities or bonds, but useful for investors with a low-risk approach or looking for investment vehicles to provide a modest return while between other, more long-term investments.
Investing in Property
Property investment can include your residential home, buying a rental property, or purchasing fund shares that invest in commercial buildings – it does not necessarily mean being a buy-to-let landlord or actively managing an investment property.
These funds can safeguard future purchasing power because real estate values tend to appreciate over time and increase alongside inflation.
While the property market is relatively low risk, it is also subject to more frequent changes to valuations than stocks or bonds. It is influenced by market appetite, changing environmental regulations and the costs of running and maintaining a property.
The Importance of Asset Class Diversification
Each asset class has advantages and potential pitfalls, and an effective investment approach should include an analysis of different assets, using them to balance risks and hedge potential losses.
For example, investing solely in securities could result in large capital losses if values dive – but a weighted portfolio with a mixture of stocks, bonds, and financial instruments has limited exposure to negative market movements.
Fund managers might recommend a lower-risk bond to offset a higher-risk equity stock or suggest more volatile shareholdings to provide faster returns than a long-term property fund investment.
Diversification cannot protect against losses, but it mitigates the scale of the impact on your portfolio, preserving wealth by reducing the proportion of assets exposed to risk.
Please contact Chase Buchanan at any time if you would like further information about the asset classes discussed here or for independent guidance, from one of our local offices, as to the best investments to rebalance your portfolio for long-term financial stability.