6) Asset Classes
When putting together a portfolio, there are a number of asset classes or types of investments that can be combined in different ways.
The starting point is cash and the aim of employing the other asset classes is to achieve a better return than could be achieved by leaving all of the investments on deposit.
The most common types of cash investments are bank and building society savings accounts, and money market funds. These are investment vehicles, which invest in securities, such as short-term bonds, to enable institutions and larger personal investors to invest cash for the short term.
Money held in the bank is arguably more secure than any other asset classes. But it is also likely to provide the poorest return over the long term. But it’s important to be able to pay unexpected expenses or to deal with an unexpected loss of income without tapping into your core portfolio, especially when markets are low.
There’s no sure way to protect your money from the effects of inflation. The only rule is that cash savings are generally the worst place to put your money long-term. The regular interest income is almost always lower than inflation, so you are always going to be constantly losing money.
Bonds effectively are IOUs issued by governments or companies. In return for your initial investment the issuer pays a pre-agreed regular return, which is known as the coupon, for a fixed term. At the end of that term, agrees to return your initial investment.
So depending on the financial strength of the issuer, bonds can be very low or relatively high risk. And the level of interest paid varies accordingly, with higher risk issuers needing to offer more attractive coupons to attract investment. And as long as the issuer is still solvent at the time that the bond matures investors get back the initial value of the bond.
However, during the life of the bond, its price will fluctuate to take account of a number of factors:
As cash is an alternative low risk investment, the value of government bonds is in particular affected by changes in rates. So rising base rates will tend to lead to lower government bond prices and vice versa.
The coupons paid by the majority of bonds do not change over time. Therefore high inflation reduces the real value of future coupon payments, making bonds less attractive and driving their prices lower.
The ability of the issuer to pay regular coupons and redeem the bonds at maturity is a key consideration for bond investors.
Higher risk bonds such as corporate bonds are susceptible to changes in the perceived credit worthiness of the issuer.
Equities or shares in companies are regarded as a riskier investment than bonds. But they also tend to produce superior returns over the long term. They are riskier because in the event of a company getting into financial difficulty, bond holders rank ahead of equity holders when the remaining cash is distributed. However, the superior long term future results come from the fact that unlike a bond, which matures at the same price at which it was issued, share prices can rise dramatically as a company grows.
Returns from equities are made up of changes in the share price and in some cases, dividends by the company to the investors.
Why Do Share Prices Fluctuate?
As an investor, you need to pay attention to the factors that can affect share prices and drive supply and demand. By doing so, you will be better equipped to make informed investment decisions.
It is also important to remember that share prices can go up as well as down, and past performance is no guarantee of a producing a future substantial gain.
These factors include:
By buying shares you are effectively investing in the future profitability of a company, so the operating outlook for the business is of paramount importance.
Higher profits are likely to lead to a higher share price and / or increased dividends.
Sustained losses could place a dividend or even the long term viability of the business in jeopardy.
Companies perform best in an environment of healthy economic growth, modest inflation and low rates of interest.
A poor outlook for growth could suggest waning demand for the company’s products or services.
High inflation could impact companies in the form of increased input prices. Although in some cases, companies may be able to pass this on to the consumers.
Rising rates of interest could put a strain on companies that have borrowed heavily to grow the business. So bear that in mind with the holdings in your portfolio.
As higher risk assets, equities are susceptible to changes in investor sentiment. Deterioration in risk appetite normally sees share prices fall, while a turn to positive sentiment can see equity markets, rise sharply. And we see that time and time again.
We shouldn’t under estimate the impact the news can have on share prices. A positive news story might lead to a small increase in share price, while a negative story could result in a significant drop.
The next asset class is property, which in investment terms normally means commercial real estate, for example, offices, warehouses, retail units and the like. So unlike the assets we have mentioned so far, properties are unique. Only one fund can own a particular office, building or shop.
The performance of these assets can sometimes be dominated by changes in capital values. These unusually dramatic moves in capital value illustrate another of property’s key characteristics, mamely it’s relative illiquidity compared to equities or bonds. Buying equities or bonds is normally a relatively quick and inexpensive process, but property investing involves considerable valuation and legal involvement.
The more normal state of affairs is for rental income to be the main driver of commercial property returns. Owners of property can enhance the income potential and capital value of their assets by undertaking refurbishment work or other improvements. Indeed without such work property can quickly become uncompetitive and run down. We see that in the high street, for example.
So when managed properly, the relatively stable nature of a property’s income return is key to its appeal for investors.