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Investing – The big picture Part 2 – Asset classes
In Part 1 we discussed risk and how your attitude towards risk can impact your investing decisions and the creation of an appropriate investment portfolio for your level of risk by altering the ratio of growth and defensive assets.
Now, we look at the different asset classes and which ones are defensive or growth assets.
By the end of Part 2, I hope you have a clear understanding of the investment big picture.
Asset recap
In the post on Assets & Liabilities (Are all assets good and all liabilities bad?), I touched on different types of assets.
Example of assets:
- Shares (also known as stocks).
- Property – residential, commercial, industrial.
- A business.
- Art.
- Cryptocurrency.
- Non-fungible tokens.
This is not an exhaustive list. Some of these are not traditional assets such as cryptocurrency, art or non-fungible tokens and are the realms of the rich or speculators, therefore, the focus of my discussion will be on the main asset classes that you are likely to invest in (not speculate).
Asset classes
An investment portfolio is a collection of assets. The diagram below depicts the typical set of asset classes. Definitions may vary, but this is more than good enough to start with.
An asset class is a category of investments that exhibit similar characteristics.
The investments within a single asset class are expected to:
- have similar risks and returns
- be subject to the same laws and regulations
- perform in a similar manner in particular market conditions.
Each different asset class is expected to:
- reflect different risk and return characteristics.
- perform differently in different market conditions.
From our perspective, buying shares in the Commonwealth Bank (this is not advice) will be very different from buying an investment property. And it’s important to understand the differences.
In general, as we move around the asset class wheel, the risk and potential return from an investment increases. Cash is usually (not all the time) the lowest return with the lowest risk and shares generally have the highest risk and potential return profile. Alternative investments, they are a different beast altogether. I won’t spend to much time on this area as it can be quite complex.
A good rule for investing is that if you don’t understand it, don’t invest in it.
In the beginning of your investing journey, you will most likely start off with one or a few investments and you will keep to one or two asset classes. You already have investments in one of these asset classes already – your bank account.
The fact that an asset class has similar characteristics is useful, in that it’s helpful to stay in one class for a while to learn about it before venturing out into other classes.
For example, most people’s first investment (outside of cash) will be shares in a local company or a managed fund (Domestic Shares = your home turf).
Understanding what to expect from each asset class helps you make appropriate investment decisions based on your varying needs and timeframes.
How does all this relate to you right now?
When you analyse all your money-related goals you might find that you need different tools to achieve those goals.
Most commonly, you’ll use cash, property and shares in various combinations across your lifetime. You’ll start off saving for a car or home using cash. You may buy a home (property), you’ll have a loan on the property and you may buy some shares (domestic and international).
If you have a superannuation (retirement) account, you’ll find that you are already invested across the whole range of asset classes.
An important aspect of using the asset classes is diversification. Diversification is a risk management strategy.
The chart above shows the performance of different asset classes over the last 10 years as well as the average, minimum and maximum performance.
The key message here is that in any given year nobody knows with certainty which asset class will perform the best. Therefore, don’t try and time the market or pick the hot sectors. It also highlights the importance of diversification.
Hold investments across a range of classes or at least different sectors within a particular class.
If you are a Total Growth investor (100% shares), you would invest in Australia, the US and the rest of the world (International). The US often has its own classification.
Cash is usually in the bottom performers, same for bonds (aka fixed interest). Property is all over the place and shares are highly variable too.
Diversification protects you from complete loss.
That’s also why multiple sources of income are useful. If one dries up, for example your day job, the others still bring in money.
Let’s briefly touch on the main asset classes.
Cash
For our purposes cash is:
- your bank accounts for your everyday use.
- Higher-interest savings accounts
(There are also term deposits, this involves locking money away for a set period of time)
What’s the difference?
Your bank account (as of 2021) is a transaction account. Your income is received and your purchases are taken out.
The interest rate you earn on these accounts is very low or zero.
You only want to hold what is necessary in this account.
A higher-interest savings account is a separate account that earns interest. There are a lot of conditions on these accounts around how much needs to go in each month, how much you can withdraw before you lose the bonus interest rate and so on.
Read the terms and conditions carefully. Can you meet these conditions?
These accounts are best for saving for a particular short-term goal or when the certainty of the value of your investment is critical. A key example is saving for a home deposit.
At the time of writing, 1.35% per annum was around the highest interest rate on offer.
Why is the interest on cash so low?
The chart above shows the home loan rate between 1959 and 2019. It’s has gone lower since (2021). Just think, in the late 1980’s poor home loan holders were paying 17% interest. That’s serious pain. But great if you were the lender!
The interest rate given to you from your bank is largely determined by the Reserve Bank of Australia. They change interest rates to influence the economy.
Keeping things simple, because they definitely are not, when the economy is weak they reduce the interest rate to stimulate investment (cheap loans to start or expand a business). This hopefully creates jobs and a stronger economy.
When the economy is going too well, things can come to an abrupt end. Like blowing up a balloon and eventually it pops. A perfect example of this is the lead up to the global financial crisis (GFC) in 2007 (circled in the chart). The economy was booming in the 2000’s, the interest rates increased to try and control the boom. Then bang.
Tremendous drama, economy stuffed. People out of jobs.
To get things up and going again, the Reserve Bank dropped interest rates. Interest rates are currently at the lowest in Australia’s history.
As a result, the earnings on your bank accounts are terrible.
This leads us to why holding cash now is actually risky.
You won’t lose your money, but tomorrow or next year it will be worth less than it is today.
What the ……. How can that be?
Inflation – the general increase in prices and fall in the purchasing power of money.
Inflation basically reflects the cost of living which usually increases every year.
A dare for you, ask a grandparent or parent about the cost of petrol when they first started driving. Or the price of a litre of milk.
It will be a pain full lesson on inflation.
Just visualise Abe Simpson prattling on about the old days.
“I needed a new heel for my shoe, so I decided to go to Morganville which is what they called Shelbyville in those days. So, I tied an onion to my belt which was the style at the time. Now, to take the ferry cost a nickel. And in those days, nickels had pictures of bumblebees on ’em.”
Yes grandpa!
The rate of inflation bobbles around a little bit, but in general the Reserve Bank of Australia want to keep it between 2-3%.
This means the cost of living increases by 2-3% each year.
Your bank account is paying 0.1% in a transaction account or 1.35% in a high-interest savings account.
Do the maths. The cost of living increases more than what I earn on my cash.
Hmmmm.
This means that the more you hold in cash, the less buying power you have in the future.
Say the cost of living is $100. (This is just a number to illustrate the point.)
Say you have $100 in the bank.
After one year, the cost of living increases by 3% (as an example), so now it’s $103.
However, at 0.1%, your $100 has increased to $100.10.
Your money is worth less in real terms than it did 1 year ago.
Why does this matter? Why have I strangely spent a lot of time talking about cash?
The main reason is – saving for a home deposit.
If you are saving money and you are getting nearly nothing in return, but house prices are rising at 5% a year. The longer you wait, the less you can afford to buy.
If your savings are increasing less than the increase in the deposit required to buy a home, you won’t make it unless you change strategy.
I am definitely not recommending putting your savings into shares, but you do need to rethink your strategy.
If interest rates on a bank account are 7% and house prices are increasing by 2%, you have time on your side.
But at the moment, it is not.
Cash is boring, but it is essential to understand. Mostly because it will be the asset class that you use on a daily basis.
Fixed interest
Now this really is boring. I promise this will be brief.
Fixed interest (aka bonds) are forms of debt.
If you take out a home loan, you pay interest every fortnight or month to the bank. In this instance, you are the borrower.
If you are the lender, you receive the payments.
So, if fixed interest is debt, who are the borrowers?
They could be the International, Australian or State governments or companies.
Governments raise funds they require through taxes and debt. We pay the tax and if they need more money, they borrow.
Companies can either borrow or they can issue more shares.
Within this asset class, risk can vary. But in general, these are less risky than shares.
A bond from the Australian government is pretty much rock solid (AAA). A bond from a third world county, less solid. A bond from a company can vary. From a bank that has been around for decades – that’s pretty solid. From a less reputable company – higher risk (BB or lower).
In the old days they called non-investment grade bonds Junk Bonds. Today they are called High-Yield Bonds. Sounds sexier. Gotta love the marketing people!
There is the potential to earn more, but the risk is higher.
Property
Property (or real estate) is a popular form of investment — a separate and distinct asset class with unique investment characteristics that are quite different from shares and bonds.
Most, if not all of you, would have experience in this asset class. Your home. This is called residential property.
In Australia,
- 70% of house owners are owner-occupiers (they live in the house).
- 30% of house owners are investors who rent out the house to others
- 70% of unit/apartment owners are investors.
- 30% of unit/apartment owners are owner-occupiers.
(https://www.rba.gov.au/publications/submissions/housing-and-housing-finance/inquiry-into-home-ownership/proportion-investment-housing-relative-owner-occ-housing.html)
Other types of property include:
- Commercial property – office buildings
- Industrial property – storage units, warehouses
- Retail property – shopping centres, shopping strips
- REITs – Real Estate Investment Trusts and listed on the Australian Stock Exchange (ASX) and run a portfolio of income-producing real estate assets. This is a way to access international property.
Clearly, residential property will be most relevant to you as you either rent or own a home. You may even have a residential investment property.
The main problem with property is the cost. To buy an investment property of any description requires a large initial investment.
Easy access to property can be through REITs. Either though a company listed on the ASX or as a managed fund.
The benefits of property include capital growth (property value tends to increase over time) and the income it produces via rent. Property prices are also less volatile than shares.
Property can be a good diversifier. Because the returns from property generally have a low to moderate correlation with those of other asset classes (their value responds to different factors) and can help to lower the overall volatility of returns of a diversified portfolio.
To be a successful property investor (not through REITs) requires a great deal of knowledge about the type of property you want to invest in, the area you want to invest in and the particulars of the property itself.
Complex stuff.
Domestic & International Shares
We continue up the risk-return chart to shares.
Owning shares, means taking part ownership of a company. You get a vote in who runs the company and the potential to get a share of the profits. If you own all the shares – you own the whole company.
The aim of investing in shares is to benefit from growth in the company through an increase in its share price and/or receiving income from dividends.
Shares may also be known as equities, or in the U.S., stocks. Hence the term stock market. Australians use the term share market. Although there are slight definitional differences for stocks and shares, for our purpose it is insignificant.
The Australian share market makes up about 2% of the value of the world’s share markets. The biggest being the U.S. Other big investment markets include U.K., Europe and Asia.
But products exist that allow you to invest almost anywhere.
International markets also provide access to sectors of the economy that are better developed than in Australia. For example, the technology sector in the U.S. is significantly bigger than in Australia.
Companies like Facebook (now Meta), Amazon, Alphabet (Google), Netflix and so on head a tech sector in the U.S. that is like no other.
However, you can access the international scene also by investing in Australian companies that operate on a global scale.
Going back to our asset class chart, it is easy to see that shares on average produce the highest returns but have high volatility.
That’s why shares are long-term investments. 7 years plus. This means that if you want to invest in shares be prepared to play the long game.
This chart below shows the last 50 years. When you look at statistics you need to be careful because you may not see the big picture. The Australian share market has underperformed over the last ten years (see above), but over the last 20 years has outperformed, 30 years a little more even, and 50 years similar to international shares but behind the U.S.
This again, highlights the importance of diversification. The return in U.S. shares was double that of the Australian market over the last 10 years. If you only had Australian investments, then you missed out.
However, additional risks are involved with international shares. Most notably, foreign exchange rates and potentially higher costs.
Getting access to domestic and international shares is easy but that is a topic for another day.
Alternative Assets
There is a wide range of investments that are not regarded as traditional that can be added to a portfolio to improve the diversification and the risk–return profile. These are referred to as alternative investments.
Examples include:
- Hedge funds
- Private equity
- Venture capital
- Commodities
- Art
- Peer-to-peer lending
- Collectibles
- Foreign currency
- Infrastructure (although this has become more mainstream and falls under the property banner)
Alternative investments may offer a higher return, relatively low risk and low correlation to the range of other traditional investments being employed, such as shares, bonds and property.
At this point in your journey, I would steer clear of these for now unless they are included in your superannuation investment portfolio.
Growth and Defensive Assets
If we remember this chart (below) from a previous post, it refers to defensive and growth assets within a portfolio.
Well, what are defensive and growth assets?
Defensive assets
Defensive assets are generally those that aim to provide a steady and/or stable income stream. These assets generally have lower investment risk, with more stable returns in the short term, but also generally have the potential for lower returns over the longer term.
Defensive asset classes are shown below.
Growth assets
Growth assets are generally assets that aim for capital growth. These types of assets can often have the potential for higher investment returns over the longer term, but they also tend to have higher investment risk and likelihood of their value rising and falling in the short term.
A longer timeframe is required for these investments.
Growth asset classes are shown below.
(You can have defensive alternative investments)
A simple High Growth portfolio (85% growth : 15% defensive) may look like this:
Growth Assets
Australian Shares Fund 35%
International Shares Fund 40%
Property Fund 10%
Defensive Assets
Australian Bond Fund 5%
International Bond Fund 5%
Cash 5%
It can become more complex than this. You might select 3 or 4 share funds for Australian and International shares to diversify even further. Using different investment managers is also a common form of diversification. But don’t worry about that now.
A quick look into a future post ……..
You don’t need to do all the work to achieve this. Investments are available that do this for you. Investing all around the world is very easy these days.
The Wrap
Part 1 and 2 of the bigger investment picture has tried to provide a high-level view of investing.
I know all you want to do is buy shares in whatever company. I’m fine with that. Go ahead.
But I do ask you to wait until my post on investing in shares and the multiple ways to do it. You can buy single shares or you can buy 500 or a thousand with the same amount of funds anywhere in the world.
Success comes with planning and knowledge. That’s the same for any aspect of life.
With regards to investing, the earlier you start the better.
If you want to play in the market, have a separate bucket of money for that. Trade shares, have fun and learn.
But true investing is a long-term game that requires consistency, dedication and persistence.
Considerations for the creation of your investment portfolio include:
- Your goals
- Appetite for risk and the percentage of defensive and growth assets
- Diversification
- Timeframe
- The asset classes you are comfortable with
You can either build this portfolio yourself or you can let professionals do it for you for low cost and next to no time required by you.
Learn enough to get started, then just start.
Up next …..
How to build a small seed into a “super” investment
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