There are many different types of investments: shares, bonds, property, cash. They are all different and useful for different investment objectives.
What is an asset class?
First of all, recall that an investment asset is something you buy so that it will make you money (i.e. to make a return on the asset). And the investment asset class is the type of investment you’ve made. For example a share, or a corporate bond, or a government bond, gold coins, paintings, or pork belly futures.
It is useful to think about investments by splitting them into different asset classes because investments in the same asset class will all share certain common traits. For example, corporate bonds all pay a known income, and all suffer from the risk that the issuer of the bond won’t be willing or able to carry on paying this income in the future.
Thinking about your investments by splitting them into asset classes can help you manage your investment risk and can help you find the mix of assets that suits your needs and fits with how much investment risk you are willing to take.
There are different ways of classifying investment assets into asset classes but all of them agree on the big picture. So don’t worry if you have seen slightly different classifications somewhere else. The important thing is not the precise detail of the classification – it’s how thinking about investments in terms of asset classes can help you to manage your investments better.
Different asset classes have their trade-off of investment return against investment risks. And different asset classes will have a different mix of income and capital gains.
Shares or equities
Shares or equity shares in a company are a “share” in owning that company. That gives you as the owner a share in the money made by the company (this is called the dividend – although not all companies pay dividends). You can also make money from the share going up in price.
Shares are bought and sold on stock exchanges. There are various indices of shares that provide information on how a whole market is doing. Often you can buy funds that will track an index giving you a return similar to that market as a whole.
Investing in Government bonds means lending money to the Government. In return for lending the Government money, they will pay you interest regularly (called coupon payments) and return your money (called the principal) at the end of the loan term.
Government bonds issued by developed countries are very secure because the Government has lots of ways it can make sure it has the money to pay you back. However, as events in the Eurozone have shown, nothing is truly risk-free when investing. Nevertheless, Government bonds are very low risk and because of that, they are also low returns.
Corporate bonds are like Government bonds except they are issued by companies. The big difference to Government bonds is the risk that the company will get into trouble and be unable to pay the coupons and principal on the bond, ie they will default on the bond. Bondholders may lose some or all of their investment if this happens.
Bonds are given credit ratings that tell you the risk of default (according to the credit rating agency at least). Bonds with a low risk of default have a lower yield and are called “investment grade” bonds. Bonds with a high risk of default (known as “junk bonds) have a higher yield, but remember the risk of losing your money!
Commercial property investment means investing in shops, offices, factories, or other buildings used commercially. Most retail investors would not be able to buy such property outright, and there would be a risk of putting all your eggs in one basket, so most of the time retail investors buy into commercial property funds. These funds buy and manage commercial property.
The fund makes money from the rent paid and from the property increasing in value. Because rents are fairly stable and generally only increase over time commercial property returns are usually less risky than shares but the expected returns are lower for that reason.
Sometimes it can take a while to invest in or get your money back from a commercial property fund because it would take a long time to buy and sell the underlying commercial property. Take careful notice of any special terms when investing.
You could just leave your money on deposit in the bank and earn interest. Or, for the slightly more adventurous, buy into a “money market fund” which invests in short terms loans to secure companies, which gives a similar rate of return. The disadvantage of this is that you can almost certainly get better returns on other asset classes, but you can at least be fairly sure of getting your money back if you need it.
Commodities are things people buy and sell to use – like wheat, pork belly, or gold – rather than an investment in a business directly. Commodities are divided into two types – “soft” commodities which are time-limited, like different foods, and “hard” commodities which last, such as metals or oil.
Investing directly in commodities doesn’t produce an income, it is all about capital gain. For most commodities (especially “softs”) this is about short-term market movements due to supply and demand. For some other commodities such as gold, it can also act as a store of value (almost like a currency) and so its price may be affected by other factors – such as the performance of the economy generally.
Commodities are a difficult investment area and you should take specialist advice before diving straight in.
If you have any overseas investments (e.g. Japanese shares or Italian Corporate Bonds) it might be a good idea to think of them as separate asset classes. So consider Japanese shares, American shares, UK shares separately.
Any investments in another currency add another risk – currency risks. For example what use is it if Japanese shares go up 20% if the Japanese Yen falls 20% against your home currency? You won’t have benefited at all. On the other hand, you could benefit if the Yen goes up – but you need to understand the currency risks you are taking so you can decide if you think the investment potential is worth the extra risk.
Investing overseas does offer diversification benefits – they are less tied to the performance of the economy where you live, whereas most of the asset classes based in your country would be heavily affected by your domestic economy.
Don’t forget to do your research. Thinking about your investments in terms of their asset class is not a substitute for researching each one carefully. But it is a very useful tool for managing your whole portfolio to get the most out of your investments.