What are the main asset classes?

This week, we look at the main asset classes available to UK investors. Most portfolios contain a mix of these in some proportion – with cash, equities and bonds making up the bulk.

Cash: The simplest, least-risky asset class. It gives us the immediate means to pay our bills should we lose our jobs or suffer an emergency and provides us with what the City calls “optionality”. This simply means we can use cash to buy other assets when the time is right: anyone who used the optionality of their cash to buy shares in 2009, for example, would have done very well (stocks soared).

But in the long run, cash has always delivered the lowest returns of all asset classes (interest rates on deposits add up to less than the total returns on other asset classes). It also isn’t as safe as it looks: during inflation, the value of cash can erode very rapidly: if you have £1,000 at the start of a ten-year period, during which inflation averages 4%, your cash will end up worth the equivalent of £744. That’s why we generally suggest you hold six months to a year’s worth of living costs in cash, but invest the rest.

Bonds: Essentially IOUs. You lend a government or a firm money. They give you a set return for the duration of the loan, at the end of which you get the original sum back. The difference between buying a bond and lending to a friend is that bonds are tradable: you’d have trouble getting anyone to pay you to take the loan you made to your sister off your hands, but you can sell or buy bonds on the open market. Bonds issued by the UK government are “gilts”. US government bonds are “Treasuries”. Those issued by companies are corporate bonds.

The market also grades bonds by how risky they are (how likely the borrower is to default). Most investors stick with the least risky – investment-grade bonds. Bonds have historically delivered a higher return than cash, but they can be hard hit by inflation and by interest-rate changes (when rates rise, bond prices tend to fall).

Equities/shares: When firms need money they can also sell shares. Those who buy then technically own a stake in the firm and are entitled to the profits paid out as dividends. Historically, the best long-term returns have come from shares – 5%-6% a year after inflation. However, equities also come with substantial risk: individual company collapses can leave investors with nothing and market crashes (which come around fairly often) can take out 30% of everyone’s capital in a year or less.

Commodities: A huge range of physical goods – from the pork bellies of Trading Places fame to oil, iron ore, copper and gold. Investors don’t buy these directly (our garages aren’t big enough). Instead, we buy funds which trade them, buy shares in the companies that dig them out of the ground, spread bet on them, or buy futures contracts on them.

The reason to invest in commodities is diversification: their prices often move in different directions to those of equities and bonds, so if you are losing on one, you are gaining on another. However, commodities themselves provide no income – no dividends and no interest. So if you want to maintain the buying power of your money, you have to hope that commodity prices keep up with inflation. That hasn’t always been the case. Of all the commodities, gold is the most important – we will devote a briefing to it in the near future.

Property: This doesn’t mean your house, but owning commercial property (mostly via funds) and getting a yield from the rents paid by the tenants. Residential also counts if it produces a yield. Investing in a residential fund or a spread of buy-to-let properties could count (although it doesn’t help with diversifying if you already have wealth tied up in your own home). A holiday home doesn’t count. Commercial property is a good diversifier and has provided reasonable long-term returns. However, like equity markets, it is prone to boom and bust and, unlike equity markets, it is illiquid. So if there is a crisis it can be hard to get your money out of a fund (because the managers will find it hard to sell the buildings in the fund).

Alternatives: The word refers to all manner of other things – hedge funds, private equity, forestry, renewable energy and currencies being the main ones.

Collectibles: Art, classic cars, wine, stamps and the like. They are hard to value, provide no income and are driven more by fashion than by finance. We don’t really consider these to be investments – I only mention them here because other people (wrongly) do!

Merryn

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