Back in lesson 3 of this series, we saw how different assets can perform differently at different times.
But what are these assets? And why should they go their own way?
An asset is something you can own, buy, and sell. It’s the opposite of a liability.
- A house that you own is an asset.
- Your mortgage is a liability.
One person’s asset can be another person’s liability.
Your mortgage is a valuable asset for your bank. You’re contractually obliged to pay it back, plus interest.
The main asset classes
The natural world is divided into broad classes like mammals, fish, and fungi – and mammals are then divided into cats, monkeys, and more.
The world of investing works much the same way. Assets fall into broad groups, with subdivisions within each one.
In investing, the big groups are called asset classes.
The main ones are:
- Bonds
- Government bonds (UK Gilts or US Treasuries)
- Corporate bonds
- Shares – Also known as equities
- Property
- Commercial property
- Residential property (your house or a buy-to-let investment)
- Commodities – especially gold, but also stuff like timber, wheat, and oil
- Alternative assets
- Wine
- Paintings
- Stamps
Different asset classes perform differently for two main reasons:
- Economic conditions – Inflation, interest rates, and economic growth affect different asset classes differently, and at different times.
- Emotion – Investors (asset buyers) are by turns fearful and greedy.
More on that below.
Asset classes in (un) reality
Let’s consider a fictitious company: Brixton Unlimited Nappy Services (Stock market symbol: BUNS).
BUNS was founded in 2000 to sell nappies to mums across London.
To raise the money to get started, BUNS floated on the stock market by issuing 100,000 shares at £10 each, raising £1,000,000. These shares can now be freely traded between investors, so the price changes. Each share is a part ownership in BUNS, entitling the owners to a certain share of the company’s fortunes.
Note that only the initial flotation actually invested money into the company.
If you buy ten shares in BUNS from me, a fellow private investor, then no money goes back to BUNS. It’s similar to if you buy a 1930s semi-detached house or a Van Gogh painting – no money goes back to the builder or to the artist from these second-hand purchases.
Only shares issued directly by the company bring money back to its own coffers.
After a while BUNS wants to expand. It could issue more shares to do so – raising more money by dividing itself up to increase the shares in issue to say 200,000 – but that would dilute existing shareholders and reduce the price of existing shares.
Many BUNS directors are also BUNS shareholders, and they don’t like the sound of that!
Instead it issues 100,000 bonds at £1 each. These bonds promise to pay the owner 10% interest every year for 10 years, at which time they will be redeemed by the company (cancelled) and anyone owning the bonds will get £1 back.
The bond issue raises £100,000. The company spends £60,000 of it buying and fitting out a new nappy shop in Chiswick – an investment in commercial property. It keeps the other £40,000 as cash in the bank for future investment. The annual interest due to the bondholders is paid from the company’s earnings.
After a while, the managers get fed up with the price of their nappies going up due to rising raw material costs. They spend £30,000 to buy an exchange-traded fund (ETF) tracking commodities like cotton. They hope that if cotton prices go up, reducing profit margins, this will be partly offset by the ETF price rising.
Business goes well, and soon BUNS is making millions. It can easily pay the interest on its bonds and also pay shareholders an increasing dividend.
Eventually success goes to the directors’ heads, and they decide they deserve to work in classier surroundings. They’re also a bit bored of the boring nappy business. They buy several trendy paintings by the graffiti artist Banksy for the office.
They tell shareholders that the paintings are an investment in alternative assets!
Asset classes and risks and rewards
Different asset classes have their own risk versus reward traits.
We’ve already seen, for example, how cash is the safest asset class. The riskiest mainstream asset class is shares, but the rewards can be higher, too.
As we saw in lesson three, however, a lot depends on when you buy your assets.
Asset classes or sub-classes can become overvalued as a whole – think Spanish property in 2008 or meme stocks in 2021 – as well as undervalued.
But the risk/reward tends to follow this fun graph:
Risk and potential reward rises towards the top right of the graph.
Asset classes and diversification
Note the difference between an asset class, and an asset within that class:
- Tesco and Barclays shares are both assets from within the equities asset class.
- Cash you keep in a Barclays bank account is from an entirely different asset class – cash.
Some investors think they are well-diversified because they have a portfolio of 20 different companies.
But all those holdings are from the same class: shares!
- Vertical diversification – Splits money between several different asset classes.
- Horizontal diversification – Hold different assets within an asset class.
To achieve a well-diversified portfolio, an investor first divides her money between different asset classes, and then further spreads it around by buying different assets with each sub-division.
For example, allocating 20% of your money to equities gives you that exposure to the asset class of shares 1.
If you put that 20% equity allocation into a UK index-tracking fund, then it’s further spread across the many companies that make up the UK index. Choose a global tracker fund and your investment is spread even more widely.
- Vertical diversification helps protect you from stuff like a stock market crash or a property slump – or from missing gains because all your money is in cash.
- Horizontal diversification protects you from local troubles, such as a company making a loss, or an individual bond issuer defaulting on the income it owes you.
The philosopher Francis Bacon had all this figured out 400 years ago, writing:
Money is like muck. No good unless spread.
By muck he means animal manure. Great if spread about to fertilize future crops. A potentially stinking liability if left in a pile in one corner!
Why do the asset classes move differently?
I’ve explained how diversification across different assets helps spread your risk.
Put simply: when one asset is zigging there’s a chance another is zagging.
But why is this the case? They’re all investments, after all. So why should bonds ever go up, say, when shares go down?
Well, the first thing to say is they might not. Diversification is not a panacea.
Investors talk about the correlation between different asset classes, which is a way of describing how they tend to move versus one another. And almost all assets are somewhat correlated with the others. There’s no precise formula you can use to create perfectly offsetting combinations of assets in your portfolio.
Okay, so with that said, why aren’t they all perfectly correlated?
Essentially it’s because different asset classes respond differently to changes in the economy – and also to shifts in fear and greed among the investing masses.
Your pain is my gain
For example, imagine that inflation suddenly jumps.
Cash in the bank becomes less attractive because rising prices erode its purchasing power.
Nominal bonds may also suffer, especially if interest rates rise to combat inflation.
However companies might eventually pass the higher costs onto customers, and so their profits can recover. Property rents may increase, helping to support valuations.
Over the long run, these asset classes have generally beaten inflation.
Commodity prices often rise during inflationary periods, too. That’s because they are the raw materials whose prices are increasing in the first place.
Again, none of these reactions is guaranteed. And they certainly don’t run to the same timetable.
Sometimes shares and property rise together. Bonds can go down even in a stock market crash. And one asset class can have a great year while another struggles.
This imperfect relationship is exactly why investors diversify. Rather than trying to predict which asset class will be next year’s winner, you follow Francis Bacon’s advice and spread your muck around!
Asset allocation and you
Owning a diversified portfolio means you’ll never do as well in a particular year as you would if you only owned the best-performing asset.
But you will also avoid having all your money in the worst. And sometimes – such as when stock markets crash – you’ll be very grateful for that.
Over long periods, a diversified portfolio will very likely deliver a smoother journey than betting it all on a single asset.
So should you own a bit of everything, then?
Well, the long answer is a bit beyond the scope of this investing lesson.
But the short answer is: not really.
Most private investors build their portfolios from just one to three asset classes.
A handful of appropriate funds – with a well-diversified equity fund at the heart of the portfolio, typically married with high-quality bonds – has long been seen as the gold standard for set-and-forget investing for the masses.
This sort of diversification – the so-called 60/40 portfolio – is core to very popular fund-of-funds like Vanguard’s LifeStrategy offerings.
Just tweak your equity exposure to match your risk tolerance and then get back to Netflix.
Beyond the beginner stage
There was a time when the 60/40 was central to Monevator thinking, too.
However our take has evolved, and we now have doubts that standard government bonds alone will always provide sufficient diversification:
- Why a diversified portfolio needs more than bonds
- The 60/40 portfolio’s glaring weakness
- How to improve the 60/40 portfolio
- The minimal viable alternative to the 60/40 [Members]
With all that said (and read!) if you’re a beginner, I’d still suggest getting started with a very simple asset allocation.
Leave the complications for a few years down the line when you’ve amassed some capital to think about preserving. Otherwise you risk being overwhelmed and never starting.
Long-term investing success usually depends more on regularly saving, keeping costs low, and maintaining an appropriate balance between shares and safer assets than on owning every asset class that you can muster some enthusiasm for.
Key takeaways
- There are only six main asset classes that you really need to know about: Cash, shares, bonds, property, commodities, alternative assets.
- Different experts classify assets slightly differently, but these six broad groups cover almost everything most investors encounter. (If in doubt – say, Bitcoin – I’d usually call it an alternative asset.)
- Within each asset class are many different specific assets.
- Good diversification is spread between asset classes, as well as assets.
This is one of an occasional series on investing for beginners. You can subscribe to get our articles emailed to you and you’ll never miss a lesson! Why not tell a friend to help them get started?
- Remember: Equities is just a fancier word for shares.[↩]
