For this weeks blog, I thought I would go back to the basics slightly and talk through the different types of assets that you can invest in.

Everybody will own cash and mostly understand that asset class. In addition, most people own and partially understand property. Some people will also own equities in companies that they are interested in, but may not fully understand how that asset functions.

So here are the asset classes we invest in our portfolios…

Cash

Cash is the most simple and lowest risk asset class there is, meaning least reward. Having said that, there are a couple of ways to invest in cash that have different return levels.

Firstly, you can have cash sat in a current account, where there is usually little to no interest return because banks don’t want to pay interest on funds that can be withdrawn any time. Another option is depositing cash into a savings account which tend to pay a small amount of interest due to the funds being more reliably available for banks to use as there’s often less withdrawals. These can be fixed term and/or fixed rate so it’s worth noting if it is fixed or flexible.

A way of retrieving slightly more return than standard bank accounts is money market funds – these are investments funds that invest in very high liquidity assets, so in a way act like cash in that you can retrieve your funds at short notice, but the key difference being that they are invested into low-risk assets like treasury bonds or high quality corporate bonds with very short maturities to make returns slightly higher. The drawbacks to money market funds are that they are slightly less liquid than cash in a bank account, there is often a minimum initial investment amount, and they can limit the amount of withdrawals you can take.

Even though cash is the least risky asset class, it does still carry its risks. Firstly, there’s the risk that the deposit taker defaults which can result in loss of capital. If this happens, the Financial Services Compensation Scheme guarantees £85,000 is returned to the depositor.  Also, if the account is fixed rate and interest rates increase, you would receive less returns than what’s available on the market. In addition, if inflation increases drastically and interest is fixed, the real return can actually turn negative if the interest is less than the inflation rate.

Fixed Income

Fixed income assets pay a regular income in return for lending cash to the issuer, over a specified time period. The most common form being government and corporate bonds where the investor lends money to the issuer (corporation or government) in exchange for periodic dividend payments, until maturity where the bond expires, and the issuer must repay the initial sum back to the investor. It is seen as lower risk than equity as it’s a predictable income stream.

The dividend you receive from these are fixed (hence the term ‘fixed income’) so the risk comes from the stability of the issuer (their credit rating, business size, financial history etc). Higher risk firms have worse credit ratings and may be smaller firms that haven’t been operating for very long, so the risk is the firm gets into financial difficulties and can’t afford to pay the dividend, or defaults and goes into liquidation which would make the bond worthless.

Bonds don’t have to be held until maturity and can be bought and sold throughout their term. This causes interest rate risk to be a concern as when interest rates rise, the bond will fall in value and vice versa, when interest rates fall the bond will increase in value. The perks of these assets are that they have varying levels of risk so you can choose how risky or safe you want to go (government of a large country being the least risky and corporate of a higher risk firm being the riskiest).

Equity

Equities are shares in companies, which represent partial ownership of the company, meaning you have a claim on the assets and income, and often have voting rights on the company’s decisions.

You can either buy shares directly in a specific company, or you can buy shares in funds who then invest into multiple underlying companies. The latter is a more diversified option so should have less risk with still potentially high rewards.

Some companies will choose to pay their shareholders a dividend, which is usually paid out periodically and represent a share of the company’s earnings. Companies that are fairly well-established so are more value focussed rather than growth will often pay a dividend because the earnings aren’t necessarily needed to support the business development. Whereas companies that are more focussed on their growth are less likely to pay a dividend as the funds are needed to be put back into the business to fund its growth.

Investors can also profit from capital appreciation – as the company grows and gets more profitable, the share price should increase. Having said that, share prices often fluctuate and nobody can predict with certainty what share prices will do so there is always a risk they can go down as well as up.

There are different types of shares that a company can issue – the main ones being ordinary and preference. Ordinary shares have the least amount of protection, so if the company goes into liquidation or there aren’t enough profits to pay all the dividends, ordinary shareholders are paid after all preference shareholders have been paid. Therefore, ordinary shares are usually cheaper than preference shares but should still receive the same returns as long as the company has enough profits to pay all dividends and doesn’t go into liquidation.

There are different ways of categorising equity holdings – size (small-cap, mid-cap or large-cap), industry sector (e.g. healthcare, technology, finance etc), geographical location (UK, US, Europe, Asia etc) and investment style (growth or value). Often, portfolios should be diversified across all of these areas to spread risk.

Property

People own property to either renovate and sell on or to rent out for a regular income and hopefully a gradual capital gain. There are three types of property you can own: residential, commercial and agricultural. Residential has the most regulations around renting like EPC ratings and gas safety certificates etc, and therefore often costs. Commercial can be anything from a shop to an office to a warehouse and usually offer more steady, longer term, reliable returns as have far longer leases than residential.

The main issue with owning property is the risk of having void periods where the property isn’t earning any rent, the cost and time of maintaining it and it being the least liquid asset class. To combat these issues, there are property funds that act like an equity fund in that they invest in companies that then own property, so you have indirect exposure to property, but without the illiquidity of owning property directly.

Conclusion

We use a mixture of all of these asset classes within our portfolios to spread the risk and try to get maximised returns. In theory, if fixed income is having a period of low returns, equities should be having a period of high returns, and vice versa. Of course, this isn’t always the case but in theory this is why portfolios should be split between fixed income and equities.

Hopefully that gives some clarity and insight into asset classes and the functions and risks of each one.