When an individual first decides to begin investing, the available information and choices can be overwhelming. That’s actually a significant topic of research in behavioral economics – when presented with too many choices, people often do nothing.
In light of that fact, I’d like to briefly discuss the common asset classes that are available for investors. Usually an investor will hold more than one class to provide the benefits of diversification. By owning several asset classes, there is less overall risk and less volatility (or change in the value of your investments).
I’ll structure the following classes according to risk levels. The first classes will be less risky, less volatile, and less rewarding to investors.
The main reason to own cash and cash-equivalent investments is to preserve capital in the short run. Cash investments include savings accounts, certificates of deposit, money market funds, treasury bills, and other similar investments which offer a fixed rate of return. Most are insured by the Federal Deposit Insurance Corporation (FDIC).
These investments have high liquidity (ability to be quickly converted to cash) and high stability (they aren’t likely to decline in value). They are typically used as a short term investment for goals or purchases that will take place within a relatively short period of time. They are also used to house a typical emergency fund.
The big problem with these investments is the low return they provide. In today’s economy you’ll basically get no return on your investment, leaving you with less purchasing power than your began with – after taking into account inflation.
As such, they should not be used for longer term savings or long term investing.
Fixed Income (Bonds)
Bonds are call fixed income investments because they periodically pay fixed interest payments to investors at a specified (fixed) date.
Here is how it works: You (the investor) loan money to a government or corporation. In return, they promise to pay you a fixed amount of interest and return your original investment at a specified future date.
Bonds are commonly either taxable (U.S. Treasury bonds and corporate bonds) or tax-free (like municipal bonds issued by local or State governments).
They are also typically categorized by maturity date. Short term, intermediate, long, etc. This is when the issuer pays back the investor his original principal.
Bonds are extremely sensitive to interest rate changes. If interest rates rise, the value of a previously issued bond goes down. This makes sense if you think about it. Why would a new investor pay full price for that old bond that pays a lower interest rate than the current issue? They wouldn’t. So to compensate for the lower rate on interest payments, the bond must be sold at a discount. The reverse applies if interest rates fall.
Fixed-income assets are often used as part of a diversified portfolio because they generally behave differently than stocks do. When stocks have gone down, bonds have done just fine. At the same time, returns on fixed-income assets have historically been lower than the returns on stocks.
Fixed-income assets are not good long-term investments by themselves. There is a good deal of research showing that owning 100% bonds is actually more risky than owning something like 75% bonds/ 25% stocks. This is because of lower growth potential and other bond risks.
The main goal of stock ownership is to provide growth and to earn returns in excess of inflation. The stock market has consistently outpaced inflation over long periods of time and has provided the highest historical returns for investors. Over the last century, stocks have averaged around 10% growth per year, and close to 7% after factoring in inflation.
When you buy a share of stock, you are buying ownership in a business’s earnings and assets. You are then entitled to receive a proportionate share of the profits through dividends and increases in the company’s share price. Mature companies are typically a better source of dividends, since rapidly growing companies often prefer to reinvest profits.
Stocks involve more risk than bonds or cash equivalents. The stock market has plummeted in value many time throughout it’s history and as a result, stocks ownership shouldn’t be considered unless the investor can keep the money invested somewhere between 5-10 years. Even then, there is considerable risk.
The absolute worst thing to do is to sell stocks when the market falls. You are locking in those huge losses instead of waiting for the recovery (which has always come).
Real estate has been a solid investment for a long, long time. The historical returns are lower than stocks, but some might consider them more stable.
Investors can own rental homes which provide continuous cash flow from tenants. This can allow the investor to pay off the mortgage and build considerable equity in the home. There are also commercial real estate opportunities and other property options.
Real estate allows easy access to leverage. With just a down payment, an investor can own a home and all the potential profit that accompanies ownership. Real estate also has nice tax privileges for primary residence sales and rental properties.
If owning and fixing physical real estate isn’t your cup of tea, consider owning Real Estate Investment Trusts (REITs). They allow you to invest in all sorts of real estate indirectly through a managing company. As an added benefit, you get better diversification.
Precious Metals and Commodities
Precious metals have long been a form of currency. I’m talking thousands of years. Investors can own physical metal or own shares of the companies that mine or trade precious metals.
Similarly, commodities are physical goods that are also frequently used or traded. Investors can own those goods directly – in the case of buying a barrel of crude oil, or indirectly – by owning companies that are involved in the harvesting, producing, or trading of these goods.
The good thing about precious metals and commodities is that they provide additional diversification benefits to investors. They often behave quite differently than stocks and bonds. The downside is that they can be extremely volatile and risky. Prices go up and down very quickly.
A Note On Mutual Funds and ETF’s
Any of the asset classes I listed can (and probably should) be owned through mutual funds or ETFs. The greatest benefit in owning these vehicles is diversification. They allow an investor to hold thousands of companies through just one investment.
For example, by owning an index ETF, an investor can hold thousands of companies – even the whole stock market – via one investment vehicle. Research indicates that owning thousands of companies is much less risky than owning just a few. As a result, returns are stronger and more stable for the investor.
Let me know if I’ve properly described the asset classes. Thanks for reading!