The term ‘asset class’ describes a set of investment options that are grouped into a similar area or type. The main asset classes are cash, fixed interest, property and shares. There is also a group of investment products that have tended to be labelled ‘alternative’ as they don’t readily fit into the parameters of the other asset classes.
The reason why it can be helpful to have an understanding of the different asset classes is that each has different levels of risk and return. Knowing what to expect can help you decide the type of investments that will suit your circumstances. You will also be able to judge your investments based on whether you prefer growth or income assets.
Every investment carries an element of risk – at best a risk that the money you make out of the investment will not be the huge wad of cash you hoped for; and at worst a risk that the whole lot will go down the drain. But the main reason that people put up with risk is that it generally comes inextricably linked to the level of return.
The trade-off between risk and return is well established – the higher the risk an investor is able or willing to take, the higher the potential rewards (but also, if a particular investment offers huge returns, it is an indication that it will come with equally huge risks).
Conventional wisdom holds that reducing risk can be achieved through diversifying where you invest. But where you invest will also be influenced by how long you are prepared to have your money tied up, your own view of that risk/reward trade-off, and your financial objectives.
Of the asset classes, cash and fixed interest both tend to be favoured by investors who are more risk averse, and who are willing to trade some potential earning power for increased security and more consistency of returns. Investment in the asset classes of property and shares have more scope to grow the capital base of your investments, but in doing so tend to be more erratic in performance while offering greater potential returns.
Cash investments include bank deposits, bank bills and short-term government bonds. There is generally no capital growth, but regular interest payments and more stable, low-risk income. When official interest rates change, cash investment rates should move in the same direction. Your investment base (the original sum of money you invested) is also available at short notice. It must be remembered however that the lower return rate will need to stay in front of the inflation rate, otherwise the investment overall goes backwards.
The slightly higher interest rates for such investments, which include bonds and term deposits, are due to the longer term nature of them. A bond, for example, can be viewed as a ‘loan’ to an entity (corporate of government) that uses the money invested (for a defined period and for a fixed rate of return) to fund various projects and activities over months or up to 30 years.
Fixed interest products can still be converted to cash very quickly, but the investor may forfeit some return for doing so. Unlike cash investments, official interest rate changes can have an inverse impact on the value of these investments. A rising rate for example will see bond prices move in the opposite direction (an investment offering 4% will be worth less once paper promising 4.5% becomes available). Also there will be no capital growth over the life of the investment.
This is not limited to tangible real estate such as houses or commercial buildings, but can include property trusts, which basically pool invested money together to buy into larger property assets. As a property can increase in value over the life of an investment, there is the real potential for capital growth. But equally there is no guarantee, and still the possibility that the value of properties can head south. As well, income returns may not be as predictable as cash or fixed interest, and will depend on aspects such as rental return, occupancy levels and the greater market conditions.
The great fluctuation in the value of shares highlights the riskier nature of this form of investment. Shares are easily traded, which makes them flexible, and also has contributed to the historically higher returns that the sharemarket can offer – astute buying and selling can make (or break) the sharemarket investor.
International shares can offer even higher returns over time, but local shares can give additional tax benefits with regards to CGT and the dividend imputation system in affect in Australia. As well, local shares are free of currency fluctuations.
Shares also potentially provide both income, through dividend payments, as well as capital growth (or loss) through changes in the value of the shares themselves. There is the potential to lose a great part of the initial money invested, but an equal potential to increase that underlying value several times. The share price itself will fluctuate depending on the conditions of the general economy as well as the performance of the particular company and the sector or industry it operates in.
There is really a fifth class of investment, but because of their nature these require a much deeper familiarity with financial tools and mechanisms. The alternative asset class includes investment in hedge funds, infrastructure bonds, fund-of-funds, commodities and futures, and derivative investments like contracts-for-difference and put and call options.
As these are very complex products that even challenge many hard-core Wall Street investors, they need to be approached with cautious enthusiasm. However used judiciously, and again because of their make-up, these alternative investments can also offer a diversification that will tend to produce lower returns in boom markets while having the potential for higher returns in down markets. As such, this is a diversification that of its nature can further even out the overall risk built in to your portfolio – which long-term can mean a smoother ride.
Alternative investments will more likely find a place in the portfolios of larger institutions or the big superannuation funds.
This article first appeared on www.taxpayersassociation.com.au