As the old saying goes, “don’t put all your eggs in one basket.” This is a valuable metaphor for explaining how to manage your investment risk. Investing money over a wide range of assets could be the key to lower risk without sacrificing the potential for higher returns.
The rationale is that if one investment goes bust, the gains from the other investments can make up for the losses. Legendary investor Sir John Templeton once said, “The only investors who shouldn’t diversify are those who are right 100% of the time.”
Investing involves risks, but diversifying one’s portfolio can lower them significantly. So, it makes sense to have some knowledge about different asset classes. An asset class is a group of investment vehicles exhibiting similar characteristics.
One asset class can never be universally better than another. Your investment objectives and market conditions can make an asset class better than another for your portfolio. When you invest your capital is at risk. This information is for educational purposes only and is not intended as investment advice.
Here is a quick look at different types of asset classes and their characteristics:
1- Cash
The asset class that is most easy to understand is cash. It does not pose any capital risk, or the risk of losing what one has invested, and is also backed by the government. Cash is also relatively liquid (in fact, the most liquid form of asset we know) and can be easily accessed.
However, it may not be appropriate to say that cash poses absolutely no risk. In an inflationary backdrop, the value of cash decreases. Although it does not pose a capital risk, its purchasing power might decrease over time.
National Savings & Investments (NS&I) is a government department offering various savings and investment options. As these are funds backed by the HM Treasury, they provide 100% security.
Cash ISAs are a type of individual savings account that pays tax-free interest on savings of up to £20,000 each year. In the UK, any person over 16 years of age can hold an ISA in their name. A fixed-rate ISA has a fixed interest rate that won’t change over the term, while a variable-rate ISA has a changeable interest rate.
2- Equities
Equities provide investors with partial ownership or a stake in a publicly listed company. These are traded openly in the stock market and are subject to the company’s general well-being. However, macroeconomic factors that the company cannot control might affect stocks.
Conventionally, equities provide better long-term returns than other lower-risk assets. You can profit from equities through a rise in the share price or by receiving dividends.
The S&P 500 index, a share index of the largest 500 companies in the USA, has delivered a 5 Year Return of 49%.
An alternative way to invest in equities is through mutual funds, which are managed asset portfolios. Investors buy units of a fund, and the money is pooled together to purchase securities. These funds are usually dedicated to an investment strategy or an industry.
Another way to invest in equities is through Exchange Traded Funds (ETFs), which are pooled investment securities that track and usually try to replicate the performances of a specific index which in turn tracks the broader market or a specific industry. Unlike mutual funds, ETFs are traded on exchanges as regular stocks. ETFs typically charge a low fee and provide investors with diverse stock trading options.
Past performance is not an indication of future performance.
3- Fixed-Rate Investments
This asset class allows investors to buy bonds or similar fixed-interest securities from a company or the government. Essentially, investors lend money to the said institutions for a relatively lower risk profile than equities. These investments are not completely risk-free, though, as institutions can default.
In the UK, an extensive range of government bonds, commonly called Gilts, can be traded. Gilts are often seen as the safest type of bond. However, the interest rate and/or yield is low, as is the norm of the risk-reward trade-off.
On the other hand, corporate bonds are securities issued by companies looking to gear up capital. These have a higher interest rate than Gilts usually. However, they are also associated with more risk as a company is more likely to default.
4- Property
Property investments can mean investing in your own property or commercial buildings like warehouses, shops, offices, etc. Property has a long history of being a solid investment option. Renting buildings out gives a steady income source which can be soothing over the burn of rising inflation.
However, these investments are long-term. Hence, it is considerably less liquid than other asset classes. Therefore, investors need to be sure they have time to settle a large financial commitment.
Residential real estate is anywhere people live, from homes to apartments to vacation houses. There are multiple setups to invest in residential real estate. The conventional buy-to-let type of property investment is buying a home and intending to rent it to tenants.
Other options like Houses in Multiple Occupations (HMOs) exist which have multiple tenants (more than two at least) who share some facilities like kitchens and toilets.
In commercial real estate, properties are leased to a business. Say an office building leased to several businesses which pay rent to the owner(s). The purview of commercial real estate also extends to its industrial counterparts, like renting warehouses and factories.
Another easy way to invest in property is through Real Estate Investment Trusts (REITs). These are companies that own real estate and can be invested through publicly-issued stocks that trade on exchanges. Therefore, investors can invest in a tricky market corner, such as real estate, without taking on the risks associated with directly owning it.
5- Commodities
Global markets also trade raw commodities. These can be fuels like oil and gas; agricultural products like wheat, rice, and dairy; industrial metals like copper, aluminium, iron, and steel; and precious metals like gold, silver, and platinum.
Commodity investments work better in inflationary environments as their prices inflate. However, they also possess a downside risk of being heavily influenced by the global economy (as we are currently experiencing). They are also influenced by factors beyond anyone’s control, i.e., nature.
Future contracts are a method of investing in commodities. These are agreements to buy and sell a specific amount of the said good and at a given date and price. These are used to hedge a portfolio or reflect on the future performance of the underlying asset. Futures are a type of derivative contract. Derivatives are particularly risky, as the assets that are invested in can be volatile and since they are usually traded on margin which means that you can lose more money than you originally invested.
Is That All?
The short answer is – no. The article does not cover several other assets with varying degrees of rewards and risks. Over the years, people have invested in several other assets to diversify their portfolios. Paintings, sculptures, and other antiques have held prominence as an unconventional asset class. Nowadays, several new asset classes have emerged, such as cryptocurrencies.
The investment space is by nature diverse, and although risks are inevitably a part of investments, a portfolio that is spread out might be better insulated from risks. Ultimately, it might be better not to place all bets on one horse.
When investing your capital is at risk. Past performance is not a guide to future performance. If you invest in currencies other than your own changes in the rate of exchange may affect the value of your investment. This information is for educational purposes and does not constitute advice or a recommendation. You should consider your own personal circumstances when making investment decisions. If you are unsure about how to proceed you should seek professional independent advice.