An introduction to asset classes

One of the most important decisions in investing is deciding on which asset class(es) to invest in. How much you should have in each is an asset allocation decision, which is usually based on two main factors – your risk capacity and your risk tolerance. You can read more about these in a separate post; in this Insight, let’s recap the key building blocks.

Equities

Equities (also called stocks and shares) is probably the first asset class that comes to mind when people think about investing, and most investors will be invested in the asset class at some stage. Essentially, owning equity means that you own a share of something, usually a publicly listed company.

As with every asset class, there are pros and cons. Equities are historically amongst the highest returning asset classes, judged over long periods of time. However, performance will fluctuate in the short term due to company-specific reasons or macro-economic cycles, so it’s important to have time on your side with equities.

There are many ways to invest in equities. You can pick your own individual stocks or invest via a fund, investment trust or ETF. Equity funds can be categorised by region, management style (see this post on active vs passive investing), investment philosophy (income, growth, value, etc), sector or theme. So even under the umbrella of equities there is a lot of choice to satisfy investors with different goals and requirements.

Bonds

Bonds is another popular asset class, usually for people who want a smoother, more predictable investment journey. In essence, bonds are loans to a company (public or private) or a government and the return is the interest on that loan. Bonds is considered to be a lower-risk asset class with more certainty than, for example, equities. The trade-off for this additional certainty, is lower expected returns over the long term.

Just like with equities, there is a lot of variation within the asset class. First of all, there are two main groups of bonds - those issued by companies, called corporate bonds, and those issued by governments, called sovereign or government bonds.

Both types of bonds are rated by independent credit rating agencies, which decide whether the bond gets an investment-grade or high-yield rating. The rating is based on the ability and willingness of the issuer (the company or government) to repay or refinance the bond. If the issuer is a blue-chip company or well capitalised government, the bonds tend to get an investment-grade rating. Conversely, high-yield ratings are usually given to bonds issued by smaller, younger and more capital-intensive companies, businesses with higher debt levels or emerging market governments. The rating is based on a higher risk of default. So, whilst bonds may have the reputation of being boring low-risk assets, there is a lot more range and complexity to be found underneath the surface.

In contrast to equities, bonds are traditionally difficult to access directly as a retail investor, though there is some innovation happening in the space to change this. But for now, if you want to invest in bonds, your best option is to do this via a bond fund.

Property

Property, also referred to as real estate, is just what it says on the tin, except that you don’t have to buy an entire house. Instead, you can become a shareholder in different types of properties or property-related companies via a fund or a real estate investment trust (REIT).

The main categories in the industry are retail, office, industrial, retail, residential and social housing. Many funds or trusts focus on just one type but some investment vehicles also offer exposure to other sides of the property market, such as property management companies, developers, construction companies etc.

Property can be a good way to add some diversification to your portfolio and tends to be less volatile than equity markets over time. It is also often used as a hedge against rising inflation – as prices go up, so do house values and rents.

However, as with equities, you need time on your side to make the most of your property investments. Property is also less liquid than equities, which makes the asset class vulnerable if too many people try to sell at once. For example, due to the COVID-19 crisis in March 2020, a significant number of property funds in the UK were forced to suspend trading for a number of months, until the markets stabilised.

Commodities

Commodities are assets that are considered to have very little differentiation and are often used in the production of other goods and services. You can invest in anything from livestock to grains, but most investors tend to stick to just two types of commodities: oil and gold.

Commodities are usually traded on specific exchanges. As an investor, you can access the asset class through derivates or via commodity focused funds or exchange-traded funds (ETFs). If you’re new to commodity investing, a fund is by far the easiest option.

Commodities are usually used as another way to diversify your portfolio, since they have historically had negative correlation to bonds or equities. And just as with property, the asset class is often used to protect from inflation. However, investors should bear in mind that commodities is a highly volatile asset class and it doesn’t produce any income, unlike bonds, property and some equities.

Alternatives

Alternatives is an asset class that encapsulates a number of other types of investments, from private equity to infrastructure to art and even wine!

Just like the name suggest, alternatives look beyond the more traditional asset classes and offer investors exposure to more niche assets. However, these investments can often need long cycles for returns to really shine, so patience is advised. And like in the case of property, alternatives tend to be less liquid and harder to sell at short notice.

Cash

And last, but not least, good old pounds and pennies is a separate asset class. As we’ve explained in a previous post, cash is good for storing money you may need immediate access to in the short-term, but not so great as a long-term investment (unless you think the world is about to end), as the interest you receive on your savings is unlikely to match inflation.

There you have it, an introduction to asset classes. Of course, the hard work is deciding which ones are right for your portfolio, when, and in what proportion. But fear not! We’ve got Insights to help with that too!

Date of publication: 25th July 2020

Date of revisions: 16th February 2023