What can I invest in? The asset classes explained
When deciding how to hold your money and arranging your finances you need to decide how much risk you want to take and therefore how much to diversify across different assets. The riskier assets tend to deliver higher returns but can be volatile, so are better held over the long term. Less risky assets such as cash are more stable, but tend not to earn you great returns – at least in an era of rock-bottom interest rates.
The five traditional asset classes are cash, bonds (or fixed-income securities), equities (or shares), property (or real estate) and commodities.
Cash can either refer to the actual cash that we carry around in our wallets, or to short-term, money market instruments.
For most investors, cash is held in a bank deposit account and earns a rate of interest paid by their bank. This is the safest way to hold funds – in a bank deposit account. The first £85,000 is protected by the state through the Financial Services Compensation Scheme, so even if the bank goes bust, that amount is guaranteed to you.
The problem is that, at the moment at least, interest rates are very poor. Savings account rates at around 1.5% mean that with inflation running at around 3%, your money, or capital, is losing value at the rate of 1.5% a year. But most people like to have some savings, a cash buffer that they can dip into as needed.
Equities or shares
Equities (also called shares or stocks) represent a proportional ownership stake in a company, entitling the shareholder to a fraction of that company’s profits in the form of dividends. A share is just a small chunk of a company, whose price is listed on a stock exchange.
In addition to the income earned from dividends, equity investors can also make money if their shares go up in value. If investors can get both, then everyone’s happy.
Equities are relatively volatile in the short-term (meaning that share prices move up and down relatively frequently) and so they are considered a risky asset.
For most beginner investors the way into holding shares is via a fund.
Private equity refers to equities in unlisted (private) companies that are not listed on a stock exchange. These shares are therefore not freely tradeable, and as a result investments in private equity are considered illiquid.
Bonds (or fixed-income)
Bonds (also known as fixed-income) are debt instruments issued by governments and companies to help finance their operations. In return for the capital that they borrow from investors (the principal), a fixed level of interest is paid (the coupon), and the principal is returned at the end of the bond’s life.
In order to reflect the risk of default, a greater level of interest is paid to higher-risk borrowers (e.g. companies and emerging market government bonds). In contrast, some government bonds (e.g. US treasuries and UK gilts) are perceived to be “default-risk free”. In addition to reactions to market sentiment, the value of bonds may change in response to the rate of inflation and central bank defined interest rates.
Commodities refer to physical goods traded in bulk quantities on markets. These include precious metals (gold, palladium, silver etc.), industrial metals (copper, steel etc), and agricultural commodities (coffee, wheat, rice).
The price of oil, metals and gems on global exchanges can be very volatile and can produce big gains or losses over short periods. Investors can get exposure to commodity markets via something called exchange traded-funds, which pretty much mirror the price of a particular commodity. Individuals can also invest directly in gold, and in shares of oil companies and mining firms. Some managed mixed funds can offer exposure to commodities or commodity shares.
Property (or real estate)
Everyone knows how much property has gone up in value – it means many of us can’t afford a home!
So it would seem to make sense that it forms a part of where we put our money.
Real estate typically refers to commercial rather than residential property. Investors can get exposure to real estate either by buying shares in property developers, or by directly investing in real estate funds. Investing in real estate can generate both income (in the form of rents) and returns from capital appreciation.
This is seen as a medium-risk, medium-return asset class – though commercial property suffered badly during the financial crisis.
As with all investments the value and the income from them may go down as well as up and investors may not get back the amounts originally invested.
Read more: Pensions: our guide to the basics