Demystifying Asset Classes
We’ve talked before about the importance of diversification in your financial plan. But not having all your eggs in one basket does not just mean one product, it means spreading your investments across a range of asset classes. So let’s have a look at what those asset classes are and what they mean as part of a well-balanced financial plan.
What Are Asset Classes?
An asset class is a grouping of investments that:
- Exhibit similar characteristics
- Subject to the same laws and regulations
- Made up of products which behave similarly to one another in the marketplace [i]
The Traditional Four
Traditionally, there were four asset classes:
- Cash – includes products like Term Deposits, traditional bank accounts and bank bills. In the current market this is very low return indeed. However, with the government guarantee on bank deposits it is virtually risk free. The only risk with this type of investment is that the low return will reduce the real value of your investment over time because the CPI is higher than the interest rate.
- Fixed Interest – essentially Bonds, which when purchased return regular interest payments. On maturity, the original sum is returned to the investor. There are different types of bonds, probably the most common are government or bank bonds. These are low risk investments as the return is determined at the time of purchase, so you know what you are getting.
- Property – there are two options for property. Direct investment in bricks and mortar; or through trusts and securities, which are traded on the stock market like shares. Due to the relatively high cost of entry and exit for direct investment in property this is usually considered a long term investment option. However, investing via trusts and securities can be used as a medium term option. Either way, property investment is generally lower risk, and often, particularly in Sydney, quite high in capital return.
- Shares – bought and sold on the stock market and generally a higher risk, higher return depending on the shares chosen. Shares can either be bought and sold directly or through products like managed funds and superannuation. Depending on your strategy and the shares involved they can be either short term or long term investments.
Alternative Asset Classes
In recent years some financial experts have expanded this list, however there is some debate over whether the new ‘alternative’ asset classes are actually classes of their own, or just sub-sets of the existing four asset classes. The key is really whether the ‘alternative’ asset improves the efficiency of your portfolio based on a given level of risk. Have a look at our earlier article on Modern Portfolio Theory to see how this works.
Generally, the new or alternative asset classes are simply different strategies within the traditional asset classes[ii]. However, let’s have a look at some of these alternative or new asset classes.
First things first, what do we mean by ‘hedge’? In financial terms, to hedge means to reduce risk. So in theory, a hedge fund aims to earn returns for investors above what would be expected with the level of risk.
They are often aggressively managed and utilize both domestic and international market opportunities. Many are designed to operate in a particular asset class area. A large investment is required to enter a hedge fund.
Despite their aggressive investment style, many hedge funds have been underperforming in recent years after a golden age during the 90’s and 2000’s.
A private equity investment is a direct investment in a privately held company that is not listed on the stock market and therefore cannot raise capital by selling shares. This is usually done via pooled funds and might include venture capital, buy-outs or growth capital.
Private equity investments are often related to start-up companies that will struggle to get traditional funding. Investors may take an active role in the management of the company via board or consulting positions or remain silent.
Commodities are raw materials, and can be either ‘hard’, such as oil and gold, or ‘soft’ such as wheat and livestock.
There are several ways to invest in commodities and which you might choose is dependent on your overall strategy, your risk profile, and the amount you have available to invest.
You may choose to invest directly, through a futures trading platform, via shares in commodities companies or via exchange trade funds.
Why you Should Invest In Different Asset Classes
This is where we talk again about diversity. If you go back to our article on Markowitz and Modern Portfolio Theory, you can see why diversity is important. In a nutshell, when one asset class is going down, you often find another is going up, thereby balancing your position, or hedging as we saw earlier.
The inclusion of low risk/return products like cash and bonds provides a solid base in a volatile environment. So whether you stick to the Traditional 4, or decide to include some of the alternative classes, having a portion of your financial plan in each class will protect you.
What percentage you put in each class will depend entirely on your objectives and your personal risk profile.
If you would like to talk about the different asset classes available to you in more detail and how this could be applied to your specific requirements, call us on (02) 9976 3388 or select ‘Interested to know more’ below.Interested in knowing more?
Take the next step
Ready to get started?
We’re here to help, whatever your needs.