Different Asset Classes
“The most important key to successful investing can be summed up in just two words -Asset Allocation.” - Michael LeBoeuf
Spreading out your investments across a variety of assets is a smart way to lower the risks involved. For this, it is important that you know the different types of asset classes wherein you may invest your savings and grow wealth for your goals. In our research, we found out that around 90% of portfolio returns are contributed by Asset Allocation. That is a huge number, so let’s dwell a bit deeper into it.
What is an Asset Class?
Common investment attributes among members of an asset class (ex: Mutual Funds and ETF’s) are the first step to defining an asset class.
Their investment characteristics include (1) the major economic factors that influence the value of the asset; (2) have a similar risk and return characteristic; and (3) have a common legal or regulatory structure.
Different Asset Classes
Equities
When you invest in equities (or stocks), you get to buy shares of a company i.e. ownership in the company in proportion to your investments. Additionally, you are entitled to get dividends from the company’s profit. As the stock price rises, your investment appreciates and you get to sell it at a higher price to pocket the profit.
Equity investments do not promise fixed returns and are therefore considered risky. However, it has the potential to yield relatively higher returns in the long run. Stocks have high liquidity and allow you the flexibility to convert these easily into cash.
Additionally, investors can also invest in stocks through Equity Mutual Funds, ETFs, Preference Shares etc. Mutual funds & ETFs are investment vehicles where investors pool their money to earn returns on their capital over a period. This corpus of funds is managed by an investment professional known as a fund manager. The gains (or losses) on the investment are shared collectively by the investors in proportion to their contribution to the fund.
Risk Profile: Investors who have a relatively high-risk profile may consider investing in stocks.
Debt
Debt or fixed income categories include securities like fixed deposits (FD), government bonds, corporate bonds, and money market instruments. These options, like bank FDs, provide a fixed rate of interest on the amount invested when you stay invested for a fixed tenure. Although, in the case of Bank FDs, liquidity is a concern, as the bank penalizes early withdrawal.
What are bonds?
A bond is a debt security. Borrowers issue bonds to raise money from investors willing to lend them money for a certain amount of time.
When you buy a bond, you are lending to the issuer, which may be a government, municipality, or corporation. In return, the issuer promises to pay you a specified rate of interest during the life of the bond and to repay the principal, also known as face value or par value of the bond, when it "matures," or comes due after a set period of time.
Risk Profile: Investors who have a conservative high-risk profile with moderate returns expectations may consider investing in stocks.
REAL ESTATE
Real estate is a valuable part of any well-diversified portfolio. There are three major reasons for adding real estate to an investment portfolio; to provide a hedge against inflation, as a portfolio diversification tool that provides exposure to a different type of systematic risk and return than stocks and bonds and to deliver strong cash flows to the portfolio through lease and rental payments.
The real estate indexes most commonly used to represent the real estate sector are the National Council of Real Estate Investment Fiduciaries (NCREIF) Property Index (NPI) and four of its components (apartments, offices, retail, and industrial properties).
REITs - REITs are securities listed on major stock exchanges that represent an interest in an underlying pool of real estate properties. Effectively, REITs operate much in the same fashion as mutual funds.
Risk Profile: Investment in Real Estate is suitable for sophisticated investors who understand the space and have huge investible surplus.
ALTERNATIVE ASSETS
As we move on from the traditional asset classes like Equity and Fixed Income to Real Estate and Alternative Assets, it gets more difficult to define parameters to define them. In most cases, Alternative assets derive their value from either the debt and equity markets – Consider Hedge Funds that derive their value by investing in debt, equity or derivatives that derive their value from one of the previously mentioned asset class.
Just for coverage purposes, Private Equity and Venture Capital investments also fall under Alternative Assets.
However, our first statement on deriving value from other asset classes does not apply to Commodities. Investment in this asset class can be achieved through various means- physical ownership of commodities like Gold, Softs, Precious metals, Oil etc. A second way, to gain exposure to Commodities is by way of owning equity in corporations that deal in such commodities (Ex: Exxon Mobil, Rio Tinto, Albermale etc.). The simplest way though, is through derivative contracts which are regulated, liquid and easy to access.
Risk Profile: Investment suitable only for professionals in commodities and derivatives.
A balanced dynamically managed portfolio of different asset classes would have a lower correlation among itself (signalling lower risk), higher return profile and most importantly diversified consistent returns.
Until next time….