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‘Asset classes’ is a term that describes groups of securities that act similarly in the marketplace. There are several different asset classes, but for individual investors, the most important are equities, bonds, cash and alternatives.
When you buy equities, you are literally buying part of a business, and becoming a co-owner, or shareholder, of that particular firm. The returns you get comes in two forms:
- Firstly, any increase in the share price, making your investment more valuable; and
- Secondly, dividends, which are your share of the profits the business makes.
Risk with Equities
If the firm goes bankrupt, as a shareholder, you’re close to the end of the line when it comes to being repaid. Investment Funds can be invested in a wide range of shares, thereby diversifying your investment and reducing your risk.
Equities are considered riskier than bonds but, on the other hand, they generally deliver higher returns over time. So, although you should expect share prices to be volatile at times, equities should, in most cases, form the largest part of a long-term investment portfolio, especially for younger investors.
However, if you put too much into equities, you run the risk that your portfolio could fall in value more than you feel comfortable with. So it makes sense to dampen the portfolio volatility with bonds. This is why the older you are, the greater the proportion of bonds in your portfolio should be – because you have less time remaining to make up the potential shortfall from share losses.
When you buy bonds, you’re lending money. There are two types of bonds:
- Government Bond: You lend money to a government agency.
- Corporate Bond: You lend money to a business.
Your returns come in the form of interest you receive on your loan.
Risk with Bonds
If the business or agency defaults on its bond, you’ll be a bit closer to the front of the queue to be paid from any capital remaining.
By holding a bond an investor is usually entitled to an annual cash interest payment that is fixed at the time of purchase. While this locked-in interest rate may seem safer, it actually exposes the investor to some risk:
For example, if inflation or short-term interest rates go up during the ‘period to maturity’, the investor loses out.
Bonds are low to medium risk investments and provide low to medium returns over time.
The third main asset class is cash. People usually invest in cash via savings accounts, money market funds and 32-day bank deposits. Money Market funds are collective investment schemes where your money is invested alongside other people’s money in cash, or cash equivalents such as short-term government loans, known as treasury bills. For more insights into investment funds, see our article ‘What does it mean to invest in an investment fund?’
Risk with Cash
Cash is considered to be the safest asset class of all, as it’s unlikely, although not impossible, that you will lose any money. The downside to this safety is that over the long term, cash usually delivers smaller returns than bonds – and considerably smaller returns than equities. Cash also carries the risk of having it’s purchasing power eroded by inflation. In reality, therefore, cash is for savers, rather than investors.
Finally, there are alternative investments – which include property, commodities, hedge funds and private equity funds. Some people also include art, classic cars and fine wines in this category. They all have their attractions and disadvantages. You may want to include alternatives in your portfolio, but the three main asset classes you should focus on are equities, bonds and cash.
Asset Class Returns
The table below shows the performance of the different asset classes ranked over various time periods.
An important principle in examining the asset classes is the time horizon and inflation. Although in the short term cash and bonds are somewhat safer, in the longer term they provide less protection against inflation. This means that for long-term investment, they are actually riskier in terms of maintaining real buying power, while property and equities are safer. Tax considerations generally accentuate these factors.
Analysis of South African experience suggests that, over time, the four asset classes are likely to produce the following real (after inflation) returns in the long run:
0 to 1%
1 to 3%
2 to 4%
7 to 9%
This does not mean that the typical investor should put all funds into shares. Such a move would subject the investor to significant short-term risk, and there is no absolute right or wrong class of investment. The investor’s time frame and objectives are both important in the choice of asset classes.
The Role of a Financial Adviser
As your goals and circumstances change, you will need to adapt your investment portfolio. Matching your goals with appropriate solutions is one of our main focus at TVC Wealth & Health Managers.
There are many other reasons Why you should talk to your financial adviser regularly.
Reach out and start your journey to financial wellness.
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