There's Only Five Places Money Can Live
When you are starting to invest, you are sure to come across the term “Asset class”. You’ve probably already heard of the different asset classes under their common names: cash, bonds, property and shares. Asset class is simply a group of investments that share similar characteristics, behave similarly in the market and are subject to the same rules and regulations.
Most importantly, each asset class comes with different risks and will produce different returns over various time periods. And understanding of how each works will help you make better investment decisions.
The main asset classes are:
Cash is thought of as the safest asset class. Even so cash is the laziest asset class, which includes bank deposits, term deposits, savings accounts and cash management trusts, it offers low risks, but also low returns. Only earning a rate of interest (which is simply inflation plus a margin for risk); It has no hedge against taxation or inflation thus, cash alone is cancer for your money over the long term. It’s easily accessible, but the big risk is inflation and taxation which consume up most of the returns, especially in the low inflation low interest environments we have right now.
Bonds or Fixed Income
Government Securities or Bonds. Similar to a loan, bonds involve lending money to companies, governments or against mortgages for a long and fixed period of time in return for regular interest payments.
While they are relatively safe and provide a reasonable return for your money, bonds do come with risks. The most important is that if interest rates rise, the value and yield of your bond will fall. Another risk is the issuer risk. That is the creditworthiness of the companies that you are lending the money to. Corporate fortunes change and tomorrows company may not be able to repay its debts or the interest payment (i.e. your loan to them). For this reason, government bonds are considered safer than corporate bonds. But to make up for the reduced risk, Government bonds pay lower yields.
Bonds offer diversification, can play an important role in your overall investment strategy and can help smooth out market volatility, but used alone, they too offer little hedge against taxation so will not provide you with the highest returns over the long-term.
Australians love property and this includes direct investments in residential, industrial and commercial property, and comes with higher risks than cash or bonds, but with lower risks than shares. Whereas it offers a hedge against both taxation and inflation the biggest issue with property is liquidity risk. (You cannot cut the front stairs off your property to raise just a little money). Income comes from the rental paid and you may enjoy capital gain or loss from a rise or fall in the value of your property.
The biggest downside is that property’s entry and exit costs are much higher than other investments. In addition to the property price, you may have to pay real estate agents’ fees, commissions, stamp duty and conveyancing fees. Property investments also require far longer time frames than other asset classes; it can take months to sell a property. You also face the risks of having the property vacant at times (Tenancy Risk) and you lack diversification as you are putting most, if not all, of your eggs in one basket.
Another way of gaining exposure to property is via listed and unlisted property trusts or funds. These require a much smaller financial outlay and provide greater liquidity and the ability to diversify your holdings. There are many options, such as Australian Real Estate Investment Trusts (A-REITs), operate like listed shares and are available on the Australian Stock Exchange (ASX). You are also able to access International property investment via a host of managed funds.
Shares - Equities
Australian and International shares allow you to own a piece of a company and can be bought on local or overseas exchanges. Australian shares only make up around 2% of the global market so diversification into International Equities is prudent.
You can also access Australian and International share market investments via exchange traded funds (ETF's) or managed funds.
Returns, like property are typically twofold or even threefold. The income generated by the dividends or earnings of the companies you own (which may be tax paid or franked because the company has already paid tax on its earnings) as well as the potential for capital gain or loss. Finally with international investment the Exchange Rate (Currency Risk) also pays a part and has the potential to enhance or detract from the overall investment return. While shares typically have good liquidity and are easy to buy and sell, they are also the most volatile asset class because of this fact. Share and currency markets can be influenced by such a wide range of factors and sentiment here and abroad with the most common being FEAR and GREED. The companies you invest in may also not perform well in the short term or worse even go broke. But over the longer term, shares have usually achieved better returns than other asset classes. For this asset class diversification is the key as it is uncommon for all companies, countries and currencies to be up or down simultaneously.
The remaining asset classes include; Commodities, Collectibles, Antiques, Gold bullion and Currency. They can also include infrastructure assets (Airports, toll roads, water and energy) as well as derivatives or alternative investments and can all be accessed via direct investment, ETFs or managed funds and private equity (which invests in unlisted companies).
Diversification - Mixing Things Up
Choosing which asset class to invest in will depend on a range of factors, including your goals, financial situation, investment time-frame and attitudes to investment risk (risk tolerance).
You are also likely to be better off having a mix of different asset classes in your portfolio – that is, simply not having all your eggs in one basket. It’s been shown that having a portfolio of different asset classes usually produces both higher returns, lower risks and less volatility for most investors.
However, putting that mix together can be confusing.
You can do it for yourself but you must remember to take TED with you. That is; you need the TIME, EXPERTISE and DESIRE to acquire all the skills you need to be successful. Alternately you can engage with an expert as there is no substitute for quality financial advice.
A qualified CERTIFIED FINANCIAL PLANNER® professional can offer valuable advice on the right combination of assets for you and your needs as well as help you develop the strategy for assembling and reviewing your portfolio.
Steve Jenkosky trading as Golden Age Advisory is an Authorised Representative of Synchron AFS License No. 243313.
Unless specifically indicated, the information contained in this BLOG post is general in nature and does not take into account your personal situation. You should consider whether the information is appropriate to your needs, and where appropriate, seek personal advice from a financial adviser.