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A quick guide to asset classes

One of the most fun things about managing your own investments is coming up with an asset [1] allocation strategy to diversify your portfolio. It’s a chance to tinker like an alchemist to find that blend of asset classes [2] that’s going to help you weather the financial storms [3] ahead, and see you dancing upon the sunlit plains of financial independence some time yonder.

So what are the asset classes that make suitable straw for your passive investing [4] nest?

The main asset classes [5]

In the rest of this post, I’ll highlight the pros and cons of the main asset classes.

This will be familiar stuff to many Monevator readers, but it’s always useful to have a frame of reference, especially as the investing world can rarely agree on a consistent definition for anything.

Cash

Filthy lucre, spondoolicks, the root of all evil… We’re all familiar with money, though perhaps not as much as we’d like to be. The simplicity and familiarity of cash is one of its biggest advantages, but excessive devotion to it can be the undoing of the cautious investor.

Good

Bad

Risk/Reward trade-off1 [8]

Time horizon

Cash is useful over any time frame, but you are likely to get poor slowly if you hold excessive amounts over the long term. Spicier investment options are needed to achieve most financial goals.

More on cash

Bonds

Bonds are I.O.U.s issued by an entity such as a company or government. In exchange for your loan, the bond issuer will pay you a guaranteed stream of interest over the loan period, plus you’ll get your original stake back after an agreed number of years. (Unless the issuer does a Greece and defaults, that is).

Passive investors should only concern themselves with investment-grade bonds, and there are strong arguments to restrict your portfolio allocation solely to domestic government bonds [10].

Good

Bad

Risk/Reward trade-off

Time horizon
You can match your bond holdings to any time horizon and know exactly what your return will be, if you hold the bonds until maturity.

Sub-classes2 [12]

More on bonds

Equities

Equities (commonly known as stocks or shares) are historically [15] the riskiest and best rewarded of our main asset classes.

That relationship is writ in stone by the laws of finance. Because equities are so risky, investors demand high potential rewards to play the game. Note that word: potential. There is no guarantee that equities will deliver; they do not provide a guarantee of income or capital. Instead, they offer part-ownership of a company and thus a claim on its future earnings.

Good

Bad

Risk/Reward trade-off

Time horizon
The longer you can hold the better. Five years is the bare minimum, 20 years is a more comfortable stretch.

Sub-classes

More on equities

Property

As an investment asset class, property (or real estate) refers to commercial property that delivers returns in the shape of rent and the appreciation of building values. It doesn’t refer to your house.

Exposure to commercial property is generally achieved through real-estate investment trusts (REITS) or ETFs. Sticking all your money in a ‘buy-to-let’ concentrates rather than diversifies your holdings and is taking a big punt on the everlasting strength of the UK property market [19].

Good

Bad

Risk/Reward trade-off

Time horizon
As per equities.

More on property

Commodities

Investing in commodities is the business of speculating on the price of cows, or oil or gold. You are betting that the future price of the asset will be higher than the current price.

However, there are very few opportunities for ordinary investors to bet directly on that spot market price because few of us can actually store several million barrels of oil.

With the exception of some precious metals like gold [23], a regular Joe’s only option is to invest in commodity funds that provide exposure to the price movements of commodity future contracts3 [24].

Commodity future funds thus don’t make their money from the onward march of the spot price but by trading futures and earning interest on collateral.

Good

Bad

Risk/Reward trade-off

Time horizon
Commodities should be thought of purely as an equity diversifier and therefore held for a similar timeframe (if at all).

Sub-classes

More on commodities

Alternative asset classes

Other asset classes exist, of course. You’ll no doubt have heard tales of the killings to be made in:

A passive investor wades into these waters at their peril. Most alternative asset classes can be discounted on some or all of the following grounds:

The bottom line is that any investor can construct a highly diversified [27] portfolio from the main asset classes: cash, bonds, equities and property, and also stirring in commodities if you’re truly convinced by its merits.

Take it steady,

The Accumulator

  1. Note, this is the expected trade-off based upon the historical returns of each asset class. Actual risks and returns can turn out very differently. [ [30]]
  2. This isn’t an exhaustive list, just a quick run-down of the more common varieties. [ [31]]
  3. An agreement to buy or sell a commodity at a particular price, at a set date in the future. [ [32]]