Asset classes explained

Asset classes explained provides a brief outline of each asset class and why you might want to hold them. It will help you in your quest to set up an investment portfolio that largely looks after itself.

On this page:
Cash
Government bonds – lower-risk rated
Government bonds – higher-risk rated
Corporate bonds – lower-risk rated
Corporate bonds – higher-risk rated
Company shares (or “stocks” or “equity”)
Gold
Property funds
Cryptocurrency aka throwing your money away
Foreign currency
Others

Cash

Cash can include both savings with instant access and ready cash in your pocket. The cash that I’m more concerned with here is the cash that you hold in your investment account (I’ll explain what an investment account is later) rather than using it to buy funds, shares or bonds. Here’s why you might keep some cash in that investment account.

Paying fees

Holding investments incurs fees. It might be the Ongoing Charges Figure (OCF) that the funds charge, the annual fee that the “platform” (i.e., the company with which you hold the investments charges) or a range of other fees. But fees there shall be.

I always want some cash in a portfolio so that the ongoing fees and transaction costs can be met without my having to sell assets in a hurry to cover those costs. Selling a car or a house in a hurry means that the buyer can offer a lower price than might otherwise be seen as fair value. The same applies to investments.

Waiting for the next financial year to top up ISAs and pensions

If tax-efficient investment “wrappers” like ISAs and pensions are available to me, I’ll use them. It might be that I’ve used my annual allowance in one or both and want to wait a few months before putting money into investments so that I can keep everything as tax-efficient as possible (i.e., legally minimising the amount of tax I have to pay).

Offsetting falls or rises in other assets – “hedging”

Holding cash can “hedge your bets” i.e., if your shares or bonds go down, then the cash you hold will stay at much the same value over the short term. This has the effect of reducing the loss across your entire portfolio.

The same works in reverse. The more cash you hold, the less you’ll benefit from rises in the shares or bonds that you hold.

Reasons for holding cash:

To pay ongoing fees/ charges – every portfolio should have at least a small amount of cash
You are waiting for a tax-efficient moment to buy investments in your pension or ISA.
You expect asset prices to go down in value – the more likely you think this is, the more cash you might be inclined to hold

Government bonds – lower-risk rated

Lower-risk bonds are referred to as “investment grade.” This applies to bonds issued (sold) by governments or companies that are considered to be financially robust.

Higher-risk bonds are referred to as “sub-investment grade”, “high-yield” or “junk” bonds. They are riskier and offer a higher yield to persuade investors to buy them. Some of them are so risky that they’re junk and you’ll be lucky to get any of your money back.

If you buy a government bond, you are effectively lending money to that government. Many governments don’t raise enough money through taxation to meet all their commitments in social welfare, roads, police, etc. So, they sell loads of bonds. There are other reasons why they sell bonds, such as maintaining stable financial markets. You can read more about these at Investopedia.com.

A bond usually has a fixed period of time before the bond issuer (the government in this case) pays the face value of the bond back to the investor (see the Glossary for more info if you want). This period of time can be three, five, 10 or 30 years. The longer the period, the more risk the investor is taking by having their money tied up in the bond. With that higher risk comes a higher return, either through a higher interest payment or a cheaper price for buying the bond.

Most government bonds pay a fixed annual interest payment, called a coupon. Some will pay a coupon that rises and falls roughly in line with inflation. These bonds are referred to as index-linked bonds, which is why they are often used to…

Counteract inflation

If you think the rate of inflation is likely to rise, you might be more likely to buy index-linked bonds because the return on those bonds would rise more or less in line with inflation. If you think inflation is likely to fall, you might go for fixed-rate bonds because they would continue to pay the same coupon even though interest rates might follow inflation rates downwards.

Income-generation

A bond that pays a fixed or index-linked coupon can be appropriate for you if you want your investments to generate an income.

Risk reduction

Bonds issued by stable governments such as those of the USA, EU and the UK (yes, I do include the UK government despite its seemingly endless shenanigans) tend to be seen as relative low risk (the UK’s risk level has increased in recent years thanks to some spectacular political incompetence).

These bond issuers have a strong track record of meeting their coupon and repayment obligations. As a result, their prices tend not to move up and down as much as the prices of bonds or shares issued by companies.

This can make holding government bonds appropriate for you if you prefer a very low-risk approach to investing. It can also help to reduce the effect that a downturn in the economy could have on your overall portfolio; share prices could fall more sharply in such circumstances.

Reasons for holding low-risk government bonds

To adjust for how you think inflation is likely to pan out
To generate an income
To reduce the level of risk in your portfolio to meet your preference

Government bonds – higher-risk rated

Argentina and Russia have failed to meet their repayment obligations in recent years. This is referred to as defaulting. As a result, the risk associated with their government bonds is much higher, meaning that they have to pay higher coupons to persuade investors to accept the risk that comes with owning their bonds.

Other factors such as a relatively unstable political or economic environment, or a currency that can go up and down a lot also increase the level of risk that comes with the relevant country’s government bonds.

Around the lowest end of the scale are US government bonds, referred to as Treasuries. Towards the upper end are Russian bonds. Spread across between them are all the other countries whose governments issue bonds. The thing to remember is which countries are recognised as offering lower-risk bonds. The rest can be considered higher risk.

If you know what you’re doing as a sophisticated investor with an understanding of risk pricing, government credentials and economic outlook, then higher-risk government bonds might be for you. But then, if that’s you, you’re probably not reading this book.

Reasons for holding high-risk government bonds

To add a higher-risk and higher potential-return asset to your portfolio.

Corporate bonds – lower-risk rated

Lots of companies raise money by issuing bonds. Some of those companies are household names with big profits and a solid outlook. As a result, their bonds are judged by rating agencies (the folk who investigate and rate how high or low the level of risk is with companies and governments).

Reasons for holding lower-risk corporate bonds

The same as holding lower-risk government bonds.
The difference is that corporate bonds tend to be slightly higher risk and offer slightly higher returns.

Corporate bonds – higher-risk rated

These don’t feature much in the portfolios I’ve put together for this book because they’re too risky.

Reasons for holding higher-risk corporate bonds

Higher potential return

Company shares (or “stocks” or “equity)

If you buy shares in a company, you own a part of that company and are entitled to a share of any profits that are paid to investors in the form of annual payments known as “dividends”.

Companies come in all shapes and sizes with almost every level of risk you can think of. Massive, profit-generating conglomerates in growing markets tend to carry lower levels of risk, which makes them attractive to lots of investors and, therefore, more expensive to buy.

New start-ups with a great idea but no revenues carry a huge risk of going bust, but one in a hundred might make it big, so sending its share price rocketing.

This is where passive funds can be ideal. With the right passive fund, you pay low fees but get access to a range of companies. In investment speak, a passive fund can provide a diversified (i.e., mixed) portfolio. But you can still select one or more passive funds to meet your needs.

I include shares in all of the portfolios I talk about later in this book. All my portfolios are invested entirely in low-cost, diversified, passive funds.

Reasons for holding shares

Lower-risk rated companies: can provide a low- to medium-risk, predictable income stream or lower potential return on investment.
Medium-risk rated companies: can provide access to more potential for growth in your investments over a number of years. Prices will go down and up during that time.
Higher-risk rated companies: these tend to be for investors with money invested elsewhere, or who are sufficiently cash-rich and debt-free to be able to invest in some risky companies that might come good but could also slump in value.

Gold

This isn’t as attractive as you might think.

It pays no interest or dividend, there’s always more of it being dug out of the ground and added to the total global stock of the stuff, it has to be verified as genuine, and it has to be kept safe from theft.

Buying actual gold might make you feel good, but you’ve almost certainly lost money on the transaction unless the price of gold shoots up. Why? Because the person most likely to buy that gold from you is the person who sold it to you. They will have added a profit margin when they sold it to you (you overpaid), and they won’t pay you what they can sell it for (they’ll underpay to buy it back from you).

Buying a passive fund that tracks the price of gold does make sense for some investors. You don’t need to worry about where to keep the stuff or whether it’s genuine. It’s also going to be relatively easy to sell your holdings in the passive fund.

”Store of value”

There are two main benefits to gold. Firstly, its price has tended to move similarly to the rate of inflation. In simple terms, this is because when people see prices rising too quickly, they don’t want to hold cash which will lose its value. A better alternative can be something that holds its value, such as gold. Hence, it’s referred to as a store of value.

This also works in reverse: when inflation falls, there can be less demand for gold sending its price down.

This doesn’t always work. The value of gold goes up and down due to a variety of factors. These can include the value of the dollar (gold is priced in dollars), how much gold is being dug up by gold miners, and any number of things that might be going on in the world.

Diversification

That’s why the second reason for holding gold is important: it’s a diversifier. Gold’s price doesn’t go up and down at the same time that shares and bonds do. Holding a small amount of gold can help to reduce the effect that price falls and rises have on your overall portfolio. It’s not for everyone, but it can have its place.

Reasons for holding gold

Store of value to counter the effects of inflation
Diversifier to counter the price falls and rises of shares and bonds

Property funds

This isn’t owning actual property (which is referred to as “direct ownership”). In this case, I’m referring to owning, surprise surprise, shares in a passive fund that owns a range of actual properties.

Being a landlord sucks. If you want to do that, be prepared for hassle and expense. I know several landlords and they’d all happily get rid of their properties if they could find a way of generating a similar income but with less hassle. If you’re good at it and enjoy it, go for it. For me, there’s too much risk (bad tenants, leaking pipes, expensive mortgages, rising interest rates, etc.)

By contrast, property funds can offer diversification in your overall portfolio without the negatives of being a landlord. The ups and downs of shares and bonds have limited relevance to the prices of property. So, if your overall portfolio is hit by a broad fall in the prices of shares or bonds, your investment in a property fund is likely to behave differently, reducing the effect of price changes on your overall investment portfolio.

There is one massive potential negative of investing in a property fund, the occasional difficulty of selling your holding in that fund. Property is illiquid i.e., it takes time and money to sell. If property prices slump, the property fund can’t sell its holdings in the properties that it owns without taking huge losses compared to what it paid for them.

However, when that does happen, lots of investors want to sell their holdings in the investment fund because the fund’s value will fall in line with the drop in property prices.

This creates a dilemma for the property fund managers. Over recent years, a number of property funds have faced this exact situation and have addressed it by banning investors from selling their holdings in the property fund i.e., a suspension in trading.

As an investor, there’s nothing you can do about this. You just have to wait until property prices recover and the fund lifts its suspension. This can take months or even years.

The lesson from this is twofold. First, including a property fund is only appropriate if you can afford to hold it for the long-term e.g., 10 years. Second, I wouldn’t allow property to dominate my portfolio; a small allocation can be appropriate either to generate income or to diversify my overall portfolio.

Reasons to hold property

Diversification

Crypto currencies – aka throwing your money away

Cryptocurrencies such as Bitcoin and Ethereum are about as sensible as selling your organs. Don’t throw your money away.

Why are crypto currencies so horrendous? Because:

There’s no underlying revenue stream
There’s no way of knowing if the value is likely to go up or down
The trading platforms are notoriously unreliable and subject to corruption and theft
Criminals use it for money laundering
Governments have massive incentives to ban them (some already have).

Reasons for buying cryptocurrencies

A fraudster or someone who doesn’t know what they’re talking about has persuaded you it’s a good idea.
It’s not. It’s a terrible idea. Don’t do it.

Foreign currency

I include this because you might think that it makes sense to have currencies. You might think it’s quite exciting. Well, it’s certainly exciting because it’s one of the quickest ways to lose a lot of money.

I don’t include currency purchases, even US dollars, in my portfolios. There’s no point as far as I’m concerned. If you want to trade currencies then read at least three books on the subject. Start with Robbie Burns’ book, The Naked Trader’s Guide to Spread Betting.

Reasons for buying foreign currency

None for the purposes of this book.

Others

There are loads of other asset classes I haven’t covered because they’re irrelevant to what I’m trying to achieve: a low-cost investment portfolio that largely takes care of itself and gives little cause for me to worry.

If you want to play around with derivatives, overlays, leverage, etc. then feel free, but make sure you know what you’re doing.

With that in mind, here’s a sobering thought on these investment classes. A former colleague of mine used to run a team of traders for a massive bank. Traders are ruthless, not caring who loses out so long as they make money. My former colleague’s team members all operated on this mantra: “If you don’t know who in the trade is being screwed, it’s you”.

However, if there’s an investment class that you think I should have covered then drop me a line on the contact page and I’ll look into including it.