An ‘asset’ is something you can invest in which will either have an intrinsic value or produce an income.
An asset class is a group of securities that have similar characteristics, behave similarly in the marketplace and are subject to the same laws and regulations.
Different asset classes have different cash flows streams and varying degrees of risk.
Investing in several different asset classes ensures a certain amount of diversity in investment selections. As we have discussed in last week’s blog, diversification reduces risk and increases your probability of making a positive return overall.
So, what are the main asset classes?
I’m glad you asked, because between this and next week’s blog, I am going to explain the main asset classes that will typically make up the bulk of most people’s investment portfolio, whether it be in an ISA or a pension, starting with…
Equities
Equities are simply shares in companies. If you own shares in a company you become part owner of that business (albeit a minority), this means that you can benefit from any growth in the share price or receive dividends (an income payment as a bonus from the company to its shareholders). Conversely, if the share price falls then the value of your holding will also reduce.
If you have a portfolio of equities, some will make a profit, some will make a loss, some may even go bust!
Big companies with a long standing and established position may have a high share price, pay regular dividends but have low potential for share price growth.
Smaller or newer companies may have a more volatile share price and they are more likely to go bust, but they may also have huge potential for growth over time if they survive.
There are companies all over the world and their share prices will be impacted by many things.
Equities form a large part of many portfolios because, over time, evidence suggests they tend to perform better than most other asset classes, but of course there are no guarantees.
Bonds
The word ‘Bond’ means a whole host of things in personal finance and consequently it can be quite confusing. In this context we are talking about IOU’s issued by governments and companies.
If a company wants to raise money to open a new factory or expand. They can borrow the money from a bank, issue some new shares, or raise money from investors using bonds – here’s where you come in! You lend the company £100 and in return you get an IOU from that company. They promise to pay back your £100 by a given redemption date, and in the meantime, they will pay you interest each year, which is called the coupon.
That’s simple enough, but these IOUs are also traded on the stock market and so their prices rise and fall depending on market sentiment (never simple, is it? *rolls eyes*).
There are many different types of bonds, but these assets are primarily about producing income.
Bonds are commonly held in investment portfolio’s to counterbalance equity volatility.
Here’s a summary:
The big difference between equities and bonds is that people who buy shares are owners of the company while people who buy bonds are lending the company money.
Generally, buying shares mans you participate in the success or failure of the company, whilst buying bonds lets you collect interest and hopefully get your full principal back.
Historically, there has been an inverse correlation between the movement of equity and bond prices meaning that they can be used to smooth out the overall volatility of a given portfolio.
Right, that’s quite enough for this week. Next week we will cover off the other main asset classes that you should be aware of when building an investment portfolio.
In the meantime, send me an email at planning@claritylfp.co.uk if you have any questions about investing or any other financial matter, or if there is anything you would like me to cover in a future blog.
Until next time…
(The value of investments and the income they produce can fall as well as rise, you may get back less than you invested).
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