Asset Classes. Like bricks, but they can make you rich.
"So, I know that I want to invest. But what do I invest in?" If headlines in newspapers are anything to go by, stocks seem like a start. After all, dad bought stocks. Does that mean stocks are right for me? But what about gold? Who's buying that, and am I missing out? And bonds? I only learnt about those a few months ago – what other investments are there that I just don't know about? (And, umm, what exactly are bonds?) Stocks, bonds, gold, commodities... And if these should be part of my portfolio, how on earth should I know how much of each to buy?"
Relax! Read on, and you'll be one step closer to financial savvy.
But, Brussels sprouts before ice-cream. What is an asset class?
Well, stocks (also known as 'shares') are – they make up the asset class called 'Equity'. Bonds are an asset class too, known more generally as 'Fixed Income'. Gold is part of the asset class broadly referred to as 'Commodities'.
But is this idea of an ‘asset class’ just another academic categorization?
A resounding no.
The distinction between asset classes is enormous and material. Like football, cricket and baseball are to sport, asset classes are to investing. (You wouldn’t expect David Beckham to stand much of a chance pitching to Babe Ruth, would you?)
Investopedia says that an asset class is "a group of securities that exhibit similar characteristics and behave similarly in the marketplace, and are subject to the same laws and regulations." Hmm, we need to be more practical about "subject to the same laws and regulations"...
Everyone has heard of ‘shares’ before, so let’s start there. (Think of shares in Microsoft, Barclays, BMW or McDonald’s.) When you invest in shares, you’re essentially buying part of a company. As part-owner of a company, you know the risks: You could become very rich if the company becomes more successful, but you could also lose the shirt on your back if the company goes under. Risky business, but potentially highly rewarding.
Of course, all companies are different, so how your investment performs depends on the specific company in which you bought the shares. But, all shares have overwhelmingly similar characteristics: They all represent ownership stakes in companies; investments in shares carry a high amount of risk and potential return because they represent ownership stakes; and the performance of all shares is driven by the same set of factors that drive corporate profitability – mainly economic growth and innovation.
And, as most of us who've lived through the TMT (or ‘dot.com’) bubble in the late '90s and the 'financial crisis' in 2008 know all too well, all shares basically rise and fall together, which is what makes them a similar investment (in spite of how different the companies themselves seem to be). Industry lingo says that shares have a 'similar risk-return profile', meaning that they have similar amounts of risk, and a similar likelihood of making you rich (or poor, for that matter).
Revisiting the definition of an asset class from earlier: “a group of securities that exhibit similar characteristics and behave similarly in the marketplace, and are subject to the same laws and regulations." So all shares, everywhere, fall into a single asset class, called ‘Equity’.
Now, take ‘bonds’. We’ve already claimed that bonds comprise the asset class known as 'Fixed Income'. “Why are all bonds treated with same broad brush, and lumped into one asset class?” Well, when you invest in bonds, you're effectively lending someone your money – usually a company or the government of a country. In return, to compensate you for your generosity, you get paid interest. It's like playing 'bank'.
Now, if you borrowed money from a bank and then bought lottery tickets with the money and you happened to win, would you pay the bank any more than you borrowed, just because you won? Of course not. Similarly, if none of your tickets struck it lucky, do you think the bank would allow you to pay back less? No. For the same reasons, if you decided to lend your money to a company by buying a corporate bond, you wouldn’t stand to benefit if the company became enormously successful; but, you also probably won’t lose money if the company struggles. In either case, all you’ll get is the interest payments, and the lump sum back at the end.
Fixed Income is generally less risky than Equity. That is, you're not going to shoot the lights out – but, equally, you're not likely to be forced to live under your parents' roof again.
US Government bonds, Vodafone bonds or Virginia Municipality bonds are certainly somewhat different, they are all bonds... They’re all the same sort of investment, have the same sort of construction, and as investments are all driven by the same factors, namely interest rates and inflation. These similarities are overwhelmingly more important than their differences, which is why bonds all fall within the same asset class, Fixed Income.
Take a look at the graph below, which shows what $100 invested in January 1973 would be worth today had it been invested in either Equity or Fixed Income.
Asset class historical performance:
If you had invested in Equity, your investment would be subject to wild swings in value, going through big booms and busts, whereas if you had invested in Fixed Income your investment would take a smoother path in growth. In good times, Equity performs much better, but when the going gets tough, bonds offer a safer refuge.
Although the Equity investment has made the long-term investor much wealthier, the short-term performance was dreadful: After less than two years, Equity had lost almost half its value – while Fixed Income had grown by 6%. The point is that the more risk you take, the higher your expected long-term growth – although at the cost of potential loss in the near-term.
Equity and Fixed Income will no doubt play a major role in your portfolio, but there are many more asset classes to consider, each with their own behavioral characteristics and risk-return profiles. This table shows the asset classes that are available in Spotlight.
In summary: Asset classes should be thought of as the building blocks of investing, each with their own shape, color and size, and each playing a unique role in your investment portfolio – the topic of the entry on Asset Allocations.