In this post I lay out the main categories of investment, which are grouped together into ‘asset classes’. I don’t make any judgements about good or bad, right or wrong, hot or not. I simply describe what the asset classes are, with examples and links to other posts which provide more details.
Equities, or stocks
When you buy the stock of a company, you buy a share of ownership of that company. Being an owner of the company comes with the following characteristics:
- You (usually) have a right to vote on company policy, at the annual general meeting of the company. Some classes of stock come without the right to vote
- You have a claim on the company’s profits. However, since you’ve entrusted the management of the company to make management decisions for you, it is possible that management chooses not to pay out dividends (*see post) to its shareholders and instead decides to reinvest the profits back into the company.
In practice there are two main reasons why you’d buy equities.
- Capital growth. Over time, in part because the value of the national and global economy tends to increase, the value of companies increases, and so the value of stocks generally increases.
- Income. Because many stocks pay out a portion of their profits to their owners in the form of dividends, equity ownership can be a source of income for investors
Typically the higher return potential from equities comes with higher risk. The value of stocks can go down quite meaningfully if either the specific company you’ve invested in is having a hard time or the economy as a while is having a hard time. Riding out the ups and downs associated with stock markets is more likely than not to be rewarding in the end, but it is important to have a suitable time horizon over which you intend to invest.
Government bonds
When you buy a government bond, you lend money to the government. All governments borrow, to differing degrees, but some are more creditworthy than others. That is, some governments, given the strength and stability of their economies and their governance systems, are far less likely to default (not pay back the money you lent them) than others. The more creditworthy governments can borrow at lower interest rates, or put another way, you can earn a lower interest rate by lending to these governments than the less creditworthy ones.
Governments – at least the creditworthy ones such as the US, Germany and the U.K. – are extremely unlikely to default on their debt. It would mean huge upheaval in their economies and a massive loss of credibility on the global stages. Government bonds are therefore a fairly low risk asset for your portfolio. Governments don’t go bust in the same way that companies do, except for some very extreme examples.
However, if you’re investing in the government bonds of another country – one that uses a different currency to your home currency – you will have to consider currency risk. Currencies are covered as a separate asset class below.
The main reason for investing in government bonds is to provide stability to a portfolio. Government bonds can offer a way to save money and earn a higher interest rate than cash held in the bank.
Corporate bonds
Corporate bonds are just like government bonds. By buying a bond you are lending money to a borrower. But unlike government bonds, which are backed by the ‘full faith and credit’ of sovereign entities (which in many cases can ultimately just tax you for the money that they owe you, and hence can’t really go bust), corporate bonds are backed by companies. That is, you’re lending to a company, which can certainly go bust and default on its debt. Different companies of course have different creditworthiness too, but generally speaking, you can expect to earn a higher interest rate on corporate bonds than on (creditworthy) government bonds.
The main reason to invest in corporate bonds is for greater stability than equities but with more of a focus on income, which is typically higher here than in government bonds
Commodities
Commodities – such as oil, industrial metals and precious metals – are considered an ‘alternative’ asset class. For most investors, they represent a speculative asset class, ie it is not an asset class that is expected to increase in value over the long term, like equities are. Investors therefore buy and sell commodities more ‘tactically’, hoping to buy at a low price and sell at a high price.
The main reason to invest in commodities is for diversification, i.e the hope that changes in their value will help to offset changes in the value of the rest of your portfolio. But unless volatility is really your idea of risk, smoothing out fluctuations in the value of your portfolio may not be necessary. On top of that, commodities are not a very reliable diversifier anyway, owing to the uncontrollable forces that act on their value, such as the weather. Commodities are not commonly found in the everyday investor’s portfolio, primarily because of their lack of expected long term return.
Gold
Gold is separated from broad commodities. For thousands of years it has been seen as the ultimate store of value, and the only ‘currency’ that has intrinsic worth (*see post). In modern time, gold has been used as a ‘safe haven’; investors buy it when they are worried about other asset classes losing value.
It is true that gold is likely to always have value – almost everyone in the world will accept it as payment or in exchange for paper money that can be used in exchange for goods and services. As an enduring store of value, then, gold’s status as a safe haven is generally warranted.
However, gold can’t protect investors against everything. If investors are using gold as a hedge against losing money from their other investments, such as equities, then they should be careful with their assumptions about how gold behaves relative to other asset classes. A post on gold’s price behaviour in the second half of 2020 can be found here.
Property
For most people, the main and probably only property ‘investment’ they’ll ever make is their home. Although its my opinion that you should see your property as a home and not as an investment, the purchase of a property nevertheless ties up capital into an asset that can gain or lose value. Given that most homeowners intend to sell their property one day, a home is undeniably an asset.
Separate from the physical ownership and occupation of a home, investors can invest in property in other ways. By investing in open-ended and closed-ended vehicles, investors can effectively partially own a portfolio of properties and obtain investment exposures that they wouldn’t be able to obtain by investing directly in the property. For example, investors can buy units in a commercial real estate investment trust, which pools together money from multiple sources and purchases property, with the intention to generate returns from income (typically rent) or capital appreciation (disposing of assets) or both.
Property is generally considered a growth or return-generating asset, because it tends to be correlated with the business cycle and with equities. However, given slightly different drivers of returns, there is some diversification benefit to investing in property as part of a broader multi-asset class portfolio.
Currencies
Every asset comes with a currency attached to it, because every asset must be priced or valued in a particular currency. For example, if a car costs 20,000, is that £20,000 or €20,000? If the asset is denominated in your home currency – sometimes called your ‘base’ currency, then you needn’t worry about the currency risk or currency exposure associated with buying and owning that asset. However, if a GBP-based investor, for example, decides to buy US stocks, those stocks come with US dollar exposure in addition to the exposure to the stocks themselves.
Although assets cannot be separated from the currency they are denominated in, that is not true in reverse. That is, investors can gain exposure to a currency without buying an asset. This is typically done using currency derivatives which allow investors to separate currency risk from underlying asset price risk. Because of this, professional investors typically treat currency as its own class, manageable separately from other asset classes. The ability to isolate currency risk, however, is generally confined to those professional investors, since they have a ‘license’ (or account with a large bank) to use derivatives in their portfolios. Normal investors like us will typically treat currency risk as inseparable from the underlying asset; if you buy US stocks, you’re also buying the US dollar. For more technical detail on this topic, see this post.
Private assets
So far, this article has talked exclusively about public assets, that is, assets that can be bought and sold on an exchange by pretty much anyone with a brokerage account.
But some assets are not publicly traded on an exchange. In order to invest in private assets, a buyer must directly connect with a seller, without the medium of an exchange which pools together many buyers and sellers. The purchase of your home will have been a private purchase, unless it was bought at an auction (which lies somewhere in between public and private markets). Likewise, the purchase of a business from someone selling their business would also be considered a private transaction.
For investors, investing in private assets typically means giving your money to a private assets manager, such as a venture capital fund (which funds small businesses at a very early stage), a buyout fund (which tries to take a publicly traded businesses private by buying all of its stock), or a direct lending fund (which lends to companies as an alternative to those companies issuing corporate bonds or taking a loan from a bank). The private assets manager will then invest the pool of money in whatever type of private asset they specialise in, and each investor ends up being a limited partner of the fund.
Investing in private assets is not limited to professional investors, although by regulation in most jurisdictions it is limited to ‘sophisticated’ investors. The reason for this restriction is that private assets are illiquid – they cannot be sold easily once invested in. Even in an emergency, you may not be able to get your money back, or if you can, then it certainly wont be quick and it’ll probably be at a cost. Investing in very early stage companies is also extremely risky – the vast majority go bust without ever making any money.
If you qualify as a ‘sophisticated investor’ and, more importantly, you feel you can tie up some of your money for a long period of time (at least 3-5 years, probably more) with a high chance of never getting it back, then there are some options for you. Some of them don’t require huge starting investments; we’ve written separate articles on some of these: crowdfunding, peer-to-peer lending, investment trusts, physical alternatives.
We refer to lots of linked posts in this post. We hope that by following the links you can answer any questions you might have, but if anything is unclear in this post, or you have any questions relating to anything investment-related, please submit comments or questions in the section below and we’ll do our best to answer them.
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