When choosing an investment, there are many different asset classes to choose from. This article outlines the basic asset classes, classified as either defensive or growth assets. When investing, you should also consider diversifying your position. This is a process of spreading risk amongst many different assets and classes in order to reduce risk.
Defensive assets provide a low risk, stable return, however little or no increase in capital value is expected. It is important to consider the effect of inflation on all investments, particularly defensive assets. Defensive assets are generally suitable for short term investments when preservation of funds is an objective.
Cash is the most simple asset class to understand. Cash can consist of physical currency or funds held within a bank account or term deposit. There is minimal risk associated with holding cash, however the returns on cash often struggle to significantly beat inflation.
A bond is an agreement between a company (or government) and an investor. The investor lends money to the company (who is known as the issuer) and in return receives a regular payment from the company. This concept is similar to borrowing money from the bank to purchase a home; you borrow the funds and in return pay a regular interest payment to the bank. Bonds have a higher risk than cash – the face value bonds is often inversely related to interest rates. When interest rates go up, the face value of bonds goes down.
The investment return from growth assets can occur in two ways. Growth assets are expected to grow in value over time – allowing for the asset to be sold at a profit. This is known as capital growth. Additionally, regular income may occur in the form of stock dividends or property rent. Growth assets have a higher risk than defensive assets, however a much higher potential for gain. Growth assets are more suitable for long term investment as there is often higher volatility than defensive assets.
Often known as shares or equity, stocks represent ownership of a company. When you purchase shares in a company, you are purchasing a part of that company. If there are 100,000 shares in a company and you own 1,000 of them, you essentially own 1% of the company and are entitled to 1% of the profits.
This profit can either be distributed to the owners (known as shareholders) through regular cash payments known as dividends, retained by the company to promote further growth, or a mixture of both. When the company retains profits, the share price is expected to increase to reflect the extra money the company holds.
Investing in property doesn’t necessarily mean purchasing the house down the street to rent out. Commercial properties, shopping centres, airports or even carparks all fall under the category of property investment. The high cost of property often acts as a barrier to entry. Property mutual funds bring commercial property into the reach of individual investors and allow for easy diversification.
By spreading your money between multiple different investments, the impact any one investment has on your overall portfolio is lessened. This concept is known as diversification.
The saying ‘don’t put all of your eggs in one basket’ sums up diversification quite nicely. If you invest all of your money into a single company’s shares and the price halves, you have lost half of your money. If you invest in ten different companies and one of them halves in value, you have only lost 5% of your money.
Different investments can be affected by the same factors in different ways. A rise in the cost of iron ore may increase the stock price for a mining company, but lower the price of a car manufacturer. A smart investor will consider the correlation of different investments to ensure that unnecessary risk is mitigated.
Diversification through Mutual Funds
Mutual funds are sometimes known as managed funds. A mutual fund uses the money from its investors to purchase a portfolio of different shares, property or bonds. The funds of any individual investor may only be enough to purchase a few different investments, however by pooling money with other investors it is possible to gain exposure to a far greater pool of investments. Using mutual funds as part of your investment strategy is a good way to diversify your holdings.
Mutual funds are often focused on investing in a certain industry, country or company size. A professional investor known as a fund manager will determine exactly which investments should be held by the fund.
An index fund is a type of mutual fund. Unlike other mutual funds, an index fund aims to replicate a market index. If an index fund aims to replicate the S&P 500, it will purchase the same stock in the same percentages as the index. The quality of an index fund can be determined by how similarly the fund performs compared to the index it aims to replicate. Index funds may track stock market indexes, property indexes or cash/bonds.