If you’re just starting your investment journey, you’ll quickly find out that there’s a plethora of investments available to build your plan. They all have their own characteristics, and as an investor, it’s important to understand the pros and cons of each investment type, also known as an asset class. Here’s a quick introduction to the main asset classes to help you make educated investment decisions.
What are the main asset classes?
Put very simply, an asset class is a group of investments that share common characteristics. Now, financial experts have yet to agree on the exact number of asset classes – some prefer to use fewer, broader categories, whilst others use more specific classes. There’s no right or wrong answer here, just different ways to see things. For this guide, we’ll talk about six asset classes and how each of them work.
Cash and equivalents
In investing terms, cash means physical money, exactly like the notes you’ve got in your wallet. Cash equivalents include items that are similar to cash, such as savings deposits, treasury bills, and money market deposit accounts, which are savings accounts with some special features, like higher interest rates and debit card privileges.
Essentially what these investments have in common is that they’re relatively safe – in other words, they don’t fluctuate too much in value and are quite stable over time. The other advantage of holding cash is that you’ll typically get interest on your money, which means you should enjoy some profits.
However, due to being a low-risk asset class, cash investments will rarely deliver higher returns – in fact, returns may be lower compared to other asset classes. When interest rates are very low, your money will barely grow. Worse, if interest rates fall to zero or become negative, then you’ll get no returns at all. And if you’re making decent returns, the real value of your cash investments may not keep pace with inflation – the rate of inflation measures how expensive goods and services are getting year on year. To enjoy real growth, you want your investments to grow at least at the same pace as the rate of inflation, and with cash, it doesn’t always happen.
When you buy bonds, you’re typically lending money to organisations, including governments and companies, so they can pay for significant projects or expand. In return, you get a promise that you’ll get your money back, often after an agreed period, plus interest for the risk you’re taking. In the UK, loans made to the government are known as gilts (UK government bonds) and those made to companies are called ‘corporate bonds.’
Generally speaking, bonds are found on the lower side of the risk spectrum, that’s because governments and companies are committed to paying the loan back with a bit of interest. But unlike cash investments, there’s no guarantee you’ll receive interest payments or even get your money back. Governments can default, although it’s rare, and companies can go bankrupt, and if this happens, you could receive less than you initially invested. But one thing to note is that if a company ceases to exist or goes into liquidation, you could get your money back, or some of your money, before shareholder. Also, if you were to hold secured corporate bonds, the company would try to recoup some of the money by taking possession of its equipment, property, or anything else of value as repayment for the loan. As for governments, they would usually just delay the repayment of the bond or offer a reduced repayment.
Most people have heard of shares, but do you know what they are and how they work? Here’s a brief explanation. Companies need to raise money to expand their business and a common way to do this is to sell a portion of the company on the stock market where anybody can buy them. The portion you can purchase is called a share – although it can also be called a stock or an equity. Think of each share as a little slice of that business. When you buy these slices, you automatically become a shareholder in that company, and you get to own a little part of the whole business.
The value of your shares is determined by how well the company is doing against expectations. If the company underperforms, then your shares could decrease in value, and vice versa, if the company performs well and grows, your shares could be worth more. With shares, you can also receive payments from the company you’re invested in. These payments are known as dividends, and it’s up to the company to decide whether they want to reward their shareholders – they have no obligation to do so.
Since returns aren’t guaranteed, investing in shares can be quite risky and you could end up with less than you initially invested. You could also expect the value of your investments to fluctuate quite a bit over the short-term – stock markets are known to have many ups and downs over time. But it’s possible to ride out the volatility by staying calm and thinking long-term. In fact, the longer you remain invested, the more likely you are to see positive returns. For example, people who invested in the largest UK stock market, the FTSE 100, for any 10-year period between 1984 and 2020 have had an 89% chance of making a gain – and this timeframe includes many market crashes, such as Black Monday and the Global Financial Crisis in 20081! And that’s not all, over time, investing in shares can provide you with inflation beating returns. Since 1983, the FTSE 100 has returned about 6.2% a year (with re-invested dividends)2, which is way above 3.4%, the average inflation rate in the UK for the same period3.
Investing in property simply means you’re buying a house with the intention of making a profit, either through rental income, future resale of the property, or both. This type of investment is very popular as it involves buying a physical property, giving you more control as investor. You can show up and inspect your property when you want to, and if you’re letting, you can run background checks on the tenants and preserve the value of your property by doing repairs yourself. However, because it’s a physical property, it can take a bit of time to sell your investment – property is quite illiquid, which means it can be hard and take months, even years, to turn it into cash.
Investing in property is less risky than holding shares because typically, it tends to be less volatile. However, this doesn’t mean that property investments are totally safe, there’s still a risk you could lose money. If anything, the Global Financial Crisis in 2008 is a great example of this as house prices fell by 16.2%4.
Buying a house isn’t the only way to invest in property. If you don’t want to purchase a physical property, or just can’t afford it, you can invest in Real Estate Investment Trusts (REITs) – these are investment funds (hampers full of investments) that are specialised in property investments. In other words, REITs can hold different types of properties from different regions – it all depends on the aim and strategy of the fund. As an investor, you can buy shares from REITs that are listed on the stock market, and they essentially work and behave like traditional shares.
Commodities include raw materials, basic resources, agricultural or mining products that can be bought and sold, such as oil, coffee, gold, wheat, and sugar, to name a few. Commodities tend to be on the high-risk side of the spectrum as prices of certain goods can be extremely volatile. This means there’s a higher risk of losing money, however, this also means potentially higher returns, if things go well.
One benefit of holding commodities is that they can be inflation-proof. Think about it, when the price of goods and services rise, the price of commodities needed to produce these goods and services will rise in tandem, meaning the value of your investments will not be eroded by inflation. However, if people stop buying a certain type of goods or using a specific service, then certain commodities could see their value go down – that’s what happened in April 2020 when the US oil prices went down due to global lockdowns following the Covid-19 pandemic5.
Alternatives include all the investments that cannot be included in the previous classes. It can be anything, from collectibles (e.g. artwork, toys, and wine) and currencies, to insurance products and private equity (where you buy shares from a company that is not listed on the stock market). Alternative investments can be very risky due to being either highly volatile, illiquid, or requiring a high degree of expertise and knowledge. But again, if things go in your favour, then you could potentially end up with a lot of money too.
What is asset allocation?
Once you’re familiar with the different asset classes, you can start building your portfolio. But before picking your investments, you may want to decide what mix of assets you want to hold – this process is referred to as asset allocation. What percentage of cash, bonds, shares, property, commodities, and alternatives do you want in your plan? There’s no right answer here, and the way you divide your investment will depend on two main factors.
The first thing you’ll need to consider is your timeframe. How long will you be investing for? As a rule of thumb, the longer you remain invested, the more adventurous you can be. Why, you ask? Well, although markets can be very volatile over the short term, it could be possible to ride out the bumps if you stick to your investments over a number of years. On the other hand, if you’re only investing for a short period of time, then it may be wise to review your risk appetite. .
The second thing that should determine your asset allocation is your risk appetite. How would you describe your risk profile? Are you willing to lose a lot of money if there’s a chance you could end up with higher returns? Answering these questions will help you choose the right mix of investments.
Now, regardless of your risk appetite, it’s important to find ways to limit potential losses. And one thing you can do to mitigate risk is diversify your portfolio – by this we mean making sure your money is spread across different investment types. Say, you’re an adventurous investor, you may be tempted to only put your money in higher risk investments, but it could be wise to put a small amount in lower risk options, that way, you’ve got a bit of a safety net, if things were to get rough.
How to get started
Choosing the right mix of assets is no easy task and it can be time consuming. If you’re too busy or don’t feel like you know enough to do it yourself, then why not ask for help? There are many services online that can help. Robo-investing platforms, like Wealthify, are designed to do the hard work for you. You simply need to choose your risk level and how much you want to invest – you can start with just £1! Our team of experts will build you a diversified portfolio with an asset allocation that matches your investment style, and they’ll manage your Plan on an ongoing basis to keep it on track.
1: Data from Bloomberg
2: Data from Bloomberg
3: Data from ONS
The tax treatment depends on your individual circumstances and may be subject to change in the future.
Please remember the value of your investments can go down as well as up, and you could get back less than invested.