Asset Classes, or Different Types of Investment

Posted on June 7, 2020

An ‘asset’ is something with a monetary value, and ‘asset classes’ are just the different categories of assets, or types of investment.

Investment aims to be a better option than saving: that is, to produce a better return than that which would be achieved by leaving the money as a cash deposit in a bank or building society.

Cash

Cash is an asset class, and it can be considered a benchmark to judge other classes by.

Not surprisingly, bank or building society savings accounts are the most common type of cash ‘investment’. It also has to be said that, these days, they are not much of an improvement over the proverbial biscuit tin or stuffed mattress. Yes, the Financial Services Compensation Scheme (FSCS) guarantees up to £85,000 per person per qualifying (and separate) institution. And, yes, the UK government has stepped in to protect deposits with Northern Rock, RBS and Lloyds. But, even though your money is protected, the long-term return on cash savings can actually be negative in real terms.

Is your interest rate fixed – or was it only high for the first year and has now dropped? Is the current rate of inflation higher than the interest rate on your account currently? If so, then you are certainly losing money. Even if your adjusted interest means you are still making money in real terms, what tax are you paying on that savings income?

Your own personal answers to these questions may explain why cash is increasingly seen as a less attractive option by many.

Bonds (Fixed Income Securities)

As the longer name suggests, a bond is an asset with a declared return (the ‘coupon’) which is agreed in advance. In return for your loan, the bond issuer makes payments over a fixed term at this agreed rate and, at the end of the fixed term (the ‘maturity date’), your initial investment (the ‘principal’ or ‘face value’) will be returned to you – that is, so long as the institution that issued the bond is still solvent.

Bonds are not risk-free, but they are generally regarded as a safer type of asset to hold. Government bonds are very low risk, and the same FSCS protections that apply to cash savings can also apply to some types of bonds. In the case of corporate bonds, a bankrupt company must pay bondholders before shareholders.

However, although bonds come with a set coupon and the undertaking by the issuer to return the principal if held to redemption, the performance of a bond investment can depend on events subsequent to issue.

The price originally paid for the bond to the issuer is its face value, and the most you will ever receive back from the issuer. But, as bonds can and do change hands during their life cycle (this is referred to as the ‘secondary market’), the price they are traded at can – and does – vary according to their perceived value.

There are several key factors that contribute to the price (remember – not face value, but perceived value). They are:

Interest Rates

The value of cash in real terms, as an investment, has a knock-on effect on all other types of investment. Bonds are the next step up the investment ladder, government bonds particularly. Changes to the central bank’s ‘base rate’ (the rate of interest from which all other rates derive) will affect bond prices. Since the rate of interest is fixed on a Bond from outset, if bank interest rates elsewhere have gone up, the rate on an existing bond in relative term falls: higher interest rates mean lower bond values, and vice versa.

Inflation

Most bonds are issued with a coupon that does not change over the term. Just as with interest on savings, higher inflation lowers the value in real terms of future coupon payments. This will make a bond with a long term and fixed coupon less attractive, resulting in a lower price.

Credit Worthiness

Various factors can affect the market perception of the ability of the bond issuer to honour debt. If the issuer is perceived to be less likely to be able to repay its debts, then the bond value in the secondary markets will fall, and vice versa. If the issuer is a company that also issues shares, then the price of those shares can also be a factor affecting the capital value of the banks current bond issues.

When considering bonds as an asset class, the larger the coupon offered (i.e. the potential return), the higher the risk that the issuer will be unable to meet the debt obligations. It’s also important to check the individual bond issuer to be certain that you fully understand the level of protection – if any.

Equities

Purchasing equities means investing in a company via share purchase. Shareholders in a company can receive a return on that investment in two ways:

Firstly, they receive income in the form of a dividend (a share in the company’s profit);

Secondly, the shares may over time be valued higher than when they were when purchased, allowing them to be sold at a profit.

Individual equities can be perceived to be attractive because the company has in the past paid good dividends to shareholders, or has seen its share price rise consistently over time, or both.
Equities as an asset class offer the possibility of income, capital growth, or both – but they also carry the risk of little or no income (low to no dividend), and even loss of money in real terms (a share price that goes down rather than up). Plus, if the company gets into real financial difficulties and go into administration then (as explained above) those holding bonds have a prior claim to whatever money remains.

Most share prices will move both upwards and downwards on a regular basis. The main things that impact share price are:

The Company’s Profits

A share is basically a bet on the future profitability of the company. A company declaring profits will likely see its share price rise, and may also issue dividends; a company declaring losses is unlikely to issue any dividend and will likely see its share price fall.

Overall Economic Outlook

In general, most companies depend on an economy that:

  • is growing (which tends to enable demand for both goods and services);
  • has low inflation (which tends to stop prices rising rapidly); and
  • has low interest rates (which tends to encourage businesses to borrow in order to grow).

Of course, there is a lot more to it than that depending on the type of business the company is engaged in, but the proposition that all companies are connected to the economy in some way is sound.

Market Sentiment

General sentiment among investors is a factor in equity values across the board. If the market as a whole is more cautious or even pessimistic (a ‘bear market’) then share prices tend to fall, whereas confidence (a ‘bull market’) can see big increases in share prices. Investor sentiment toward a particular company, both positive and negative, can be triggered by news that the market as a whole considers (or sometimes just suspects) will have an effect on future profitability.

Only one thing is certain: equities are a more volatile – and therefore a riskier – asset class. However, they are also capable of generating better returns in the medium to long term than bonds.

Property

In the context of investment, this has historically meant commercial property (office buildings, shops, warehouses and storage units) rather than domestic property. However this has changed in recent years.

Compared to bonds or equities, both the acquisition and disposal of property are likely to be more time-consuming and more expensive (involving professional fees and sometimes sizeable duties to pay). And, for an asset class which usually requires a fairly substantial outlay and which is not exactly liquid, property can still prove to be volatile and subject to large capital value changes – for good or bad. For instance, in a buyer’s market like that which the UK saw in 2007, prices can take a hard fall. Or, when there are more buyers than sellers, as happened in 2009 immediately following the crash, there can be rapid price rises.

That said, property as an investment is primarily used to generate an income (in the form of rent) rather than to grow capital. Whilst rents are influenced to an extent by property sale prices, they are tied more closely to demand for property from occupiers, meaning that properly managed property can provide a stable income.

Buy to Let Property Investment

The last few decades have seen the cost of home ownership rise, and this has had the knock on effect of increasing demand for rental properties. Many investors in the buy to let market have seen good returns, although there have always been factors such as property upkeep, bad tenants, loan repayments and therefore interest rate rises, as well as periods of no income between lets to weigh in the balance.

Recently there have been additional considerations: 2016 saw not only big increases in stamp duty on second homes but also far less favourable tax laws for part-time landlords. These factors along with increasing interest rates have coincided with and contributed to more stringent criteria from lenders. The overall effect of all these changes has been to make property much less something to ‘dabble in’.

Asset Allocation, Correlation and Diversification

As the name suggests, asset allocation is the way your investments are divided up. Why is it a crucial factor in investment? Because, as we’ve indicated above, the value of assets in different classes are impacted by a huge range of economic, political, regulatory, social and even environmental factors.

Conditions that are beneficial to one asset or class might be detrimental to another, and this combined movement and the effect it can have on an investment portfolio comprised of a range of different assets from different classes is referred to as ‘correlation’.

This then brings us to the science of ‘diversification’: the mathematical process of mitigating the risk across an investment portfolio through optimal diversification of assets.

More than simply ‘not putting all your eggs in one basket’, proper diversification involves using complex mathematical modelling to calculate the optimal weight of each asset class in a portfolio to obtain the maximum rate of return with the least amount of aggregate portfolio risk!

Diversification is a topic in its own right and we’ve explored it here.

INFORMATION IS BASED ON OUR CURRENT UNDERSTANDING OF TAXATION LEGISLATION AND REGULATIONS. ANY LEVELS AND BASES OF, AND RELIEFS FROM, TAXATION ARE SUBJECT TO CHANGE.

THE VALUE OF INVESTMENTS AND INCOME FROM THEM MAY GO DOWN. YOU MAY NOT GET BACK THE ORIGINAL AMOUNT INVESTED. PAST PERFORMANCE IS NOT A RELIABLE INDICATOR OF FUTURE PERFORMANCE.

No guarantee can be given that the information provided is accurate in the present or the future. It is not intended to constitute either a statement of applicable law or financial advice, and responsibility cannot be accepted for any subsequent loss following activity or inactivity by any individual or organisation. Indeed, such information should NOT be acted upon without first receiving appropriate and specific professional advice.