Whether it’s taking a more active interest in our superannuation, starting to build an investment portfolio, or even trying our hands at playing the stock market, we can all benefit by understanding the language and key concepts of investing. Here’s a quick introduction:
Asset classes
Investors can group together a huge range of potential investments into asset classes that are based on shared characteristics. There are many asset classes, however the major ones that most mainstream investors focus on are shares (or equities), property, fixed interest and cash.
- Shares give investors part ownership (usually a very small part) in specific companies. The share market sets the value of each share and prices can fluctuate significantly, even from day to day. This price volatility means that, relative to other asset classes, shares are higher risk, particularly in the short term. Investors hope that shares will produce greater long-term profits than other asset types. Shares may also provide regular income in the form of dividends. It’s common to split this asset class into Australian and international shares.
- Property also provides investors with full or partial ownership of growth assets. Rent and property provide income and also have a strong history of providing capital growth. As property values can decline, it is considered a medium to high-risk asset class.
- Fixed interest refers to investment in government or corporate bonds. Bonds are a type of loan, and each bond has a maturity date (repayment date), a face value or maturity value (the amount returned at the maturity date), a coupon rate (the interest rate paid on the face value), and a market value. The coupon rate is fixed for the life of the bond (‘fixed interest’), but the market value of the bond fluctuates depending on movements in interest rates.
Fixed interest can be high or low risk. At one end of the spectrum are so-called junk bonds. It offers a high interest rate, but come with a high likelihood that they are not repaid. At the other extreme are bonds issued by large and stable governments. These bonds have such a high likelihood that they will deliver the exact return expected by an investor that they are considered, for practical purposes, to be risk-free. - Cash covers bank accounts and term deposits. Cash investments are a low risk asset classes since they offer returns in the form of interest payments.
Why are asset classes important?
One of the golden rules of investing is that when seeking higher returns. Investors must take on a greater degree of risk. As it relates to investment, risk is also the thought of as volatility or uncertainty. Quality fixed interest investments provide a high certainty of a particular return. They are low risk, and the returns they offer reflect this. However, for any given share, we don’t know what its price will be in a period. Prices may be volatile, the return is uncertain, so a share is a higher risk investment. However, that risk can be an upside risk, which is the potential for the share to generate a higher than expected return.
Asset classes bundle together investments with similar risk and return profiles. By asset allocation —blending asset classes together in different proportion — investors can construct portfolios that provide levels of risk and return that suit specific needs. Typically, a retiree may want a portfolio that minimises their risk and provides more stable returns. A 30 year old with an investment time horizon of decades may be happy to take more risk. In the knowledge that, over the long term, growth assets (shares and property) have delivered the highest returns.
This blending of different asset classes results in diversification, which is a critical risk management tool. As different asset classes over and under perform at different times, mixing different asset classes lowers the volatility, and hence the risk, of a portfolio.
According to more than 90% of research, the asset allocation affects a portfolio’s performance. It’s vastly more important than individual investment selection or the timing of purchases and sales.
Indexing
There are many different indices that track the performance of each asset class and its subclasses. The Australian All Ordinaries Index, for example, follows the fortunes of Australia’s 500 largest companies. The Australian Fixed Income Index Series tracks the performance of higher quality Australian bonds.
Given the importance of asset allocation and the difficulty of picking winning and losing shares or other assets, many investors are content to accept the performance delivered by each asset class. An easy way to achieve this is investing in index funds. With a small number of these funds, it’s possible to deliver diversification both across and within asset classes.
Help is at hand
Of course, there’s more to investing than conveyed in a short article, but that’s no reason to delay putting the various markets to work. Your licensed financial adviser can help you understand your risk comfort level, and design an investment strategy that’s right for you.
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