So here at HYW we are all about helping you save and grow your money. But in order to grow your money, you first need to know where you can invest. In this article, we will introduce all the asset classes you need to know about. Also, we will provide a brief overview over the advantages and disadvantages for each asset class.
What is an Asset Class?
Asset class refers to a group of assets that tend to behave similarly or have similar characterestics. Diversification within each asset class and across all classes is guaranteed to preserve wealth. Concentrating on a single asset class comes with risks, but that risk can payoff with focus, discipline and a little bit of luck.
1. Cash
Believe it or not, cash is an asset class. It is liquid and accepted everywhere. However, you will 100% lose money by leaving your savings in cash because of inflation. Some would argue that you need some cash set aside to make the most out of any opportunities that might arise. However, we disagree, you can still make investments in less volatile assets. See fixed income securities below that would still make some return on your cash. Now we are not saying put your emergency fund or the money that you saved up for your first home in the stock market. What we’re saying is that you can make some return in safe fixed income securities.
Cash is perceived as the safest and most stable asset class. But in reality, it is the asset class that is guaranteed to make you a loss over long periods of time. There is no need to hold too much cash for too long unless for an imminent big expenditure.
2. Fixed Income Assets
As the name implies, fixed income assets are assets that provide a fixed income to the investor. This is a broad asset class that includes saving accounts, certificates of deposit (CD’s), corporate bonds, government bonds, Islamic bonds and the list goes on. Some of these assets are very stable, almost as safe as cash, while others are volatile, almost as volatile as stocks.
Savings & CDs
Let’s start with savings accounts. Savings accounts pay interest that is closely linked to the base interest rate set by the central bank. In most developed economies, low interest rates have been the norm since the financial crisis, so these financial products have not been making any meaningful returns for more than a decade. This has been changing recently as central banks respond to rising inflation with higher interest rates. An alternative are certificates of deposit, or CD’s for short. These are financial products that are designed to generate a fixed income over a fixed period of time. Unlike savings accounts which are provided by regulated banks, CDs can be provided by unregulated institutions such as unions, shadow banks, etc. Typically the smaller the organisation, the higher the offered interest rate on the CD.
Bonds
Another important type of fixed income assets are bonds. Bonds are securitised debt. This means that when you invest in a bond, you are lending money on the basis that you would get back your money with interest. The more creditworthy the organisation you’re lending your money to, the lower the risk and the interest. That’s why US government bonds would pay a lot less than a Gamestop corporate bond. Unlike saving accounts and CDs, bonds are publicly traded. This makes them liquid (easily bought and sold). Liquidity in markets comes with a price, volatility. That is why bond values jumps up and down like the stock market but to a much lesser extent.
Islamic bonds are yet another type of bond. Islamic bonds are structured differently and are usually asset backed or asset based. This makes them more complicated financial instruments. However, they usually offer higher returns than their conventional counterparts.
In summary, fixed income assets comprise a number of financial products and securities. Some of which are very stable but offer very little income while others are a bit more volatile with more return. There are two rules of thumb when it comes to investing in bonds, the more liquid the asset, the more volatile it is. Secondly, the higher the credit risk the higher the return should be. This is merely a brief overview of this broad and important asset class. For more information, we cover bonds at greater detail here.
3. Real Estate
Real estate is a popular and usually misrepresented asset class. Of course real estate asset prices are more stable relative to publicly traded assets since they are less liquid. But that does not mean they don’t change. They are often touted for their cashflow generation feature, but it is in no way passive for most people. Being a landlord comes with many responsibilities and outsourcing tenant and property management companies comes at a cost and sometimes, risk.
Total return of real estate assets comprises two components, asset price appreciation and rental yield. Therefore, it is imperative to find and keep tenants as soon as you acquire an investment property. Perhaps the best feature of real estate is the wide use of leverage; banks are always happy to lend at competitive rates if real estate backs the debt. See how debt affects your returns on a £100,000 property in the examples below.
Example 1: Gain with Cash Purchase
Property bought for 100k in cash, sold 1 year later for 110k. Ignoring rental income for the year, the return on investment is 10k/100k=10%. Not bad.
Example 2: Gain with 75% Loan-to-Value (LTV)
This time, you bought the property with 75% LTV, meaning you borrowed 75% of the property value. In this scenario you pay 25k upfront (25% deposit) and get 75k from the bank. You sold the property 1 year later for 110k and paid the bank back the 75k. The sale leaves you with 35k, 10k of which is profit. Again ignoring rental income and interest for that year, your return is 10k/25k=40%!
You can see how debt can boost your returns. But beware, debt can also boost your losses in a market crash. See the calculations below for the same property in a market downturn.
Example 3: Loss with Cash Purchase
Property bought for 100k in cash, sold 1 year later for 90k. Ignoring rental income for the year, the loss on investment is 10k/100k=10%.
Example 4: Loss with 75% Loan-to-Value (LTV)
You pay 25k upfront (25% deposit) and get 75k from the bank. You sold the property 1 year later for 90k and paid the bank back the 75k. The sale leaves you with 15k, losing 10k. Again ignoring rental income and interest for that year, your loss is 10k/25k=40%!
In these simplified scenarios we are leaving out so many important factors that would help determine the profitability of your investment. Factors such as occupancy rate, upkeep costs, interest, taxes and transaction fees when it comes to selling. All these factors must be considered before investing.
Unfortunately, in the UK, residential real estate was such a good investment for decades that the government decided it is time to make it more difficult for investors to make money. However, that does not mean you cannot make good returns investing in UK real estate, but it means more preparation and capital is needed to make it worthwhile.
Real Estate Investment Trusts (REITs)
There is an easier and cheaper way to invest in real estate, which is through REITs. REITs are publicly traded companies that are dedicated to running and servicing a real estate portfolio for investors. Profits after costs are distributed to investors as dividends. Because they are publicly traded, REITs are very liquid and are much cheaper than buying a full property. Additionally, REITs can specialise in residential or commercial properties, ranging from hospitals to malls and even data centres. As always, expect volatility in REITs as with other liquid assets.
4. Public Equity (Stock Market)
Stocks, shares and public equity are all interchangeable terms for the same asset class. These are publicly traded assets that entitle investors to a share of future profits and a vote on how the company is run. There are different types of shares but to make things simple we will only cover common shares or common stock (learn about other stocks here). These are the most commonly traded stocks on the stock market. We make the distinction between public equity and private equity because investors can invest their money in private companies. However, we do cover such investments in the alternative investment section.
Stock Market Returns
So you might have heard that the stock market on average returns about 10% a year over the long term. This statement holds true for the US stock market. The UK stock market has returned less to investors over the long term, about 7%. Other stock markets, like the Japanese stock market, have been flat for two decades. The truth about the stock market is this, it’s closely linked to the economic growth of the country. No one wants to admit this, but the reason why the American stock market has been outperforming every other stock market is because American companies have been growing faster than most other companies. It’s also partly because the American stock market is so welcoming to foreign investors. It is widely accessible to anyone anywhere to invest in American stocks. Unlike Japanese or Chinese stocks, for instance, which are a lot more difficult to acquire.
Investors Beware
There is a caveat to investing in US stocks, past performance is not an indicator of future returns. So I can go on and on about investing strategies and stocks to put your money in. But the truth is this, no one knows what’s going to happen to the stocks in a week, a month or a year from now. Stocks are volatile, they can go up 20% in a day or down 20% in a day so the best strategy out there is to allocate some of your money to a diversified stock portfolio with exposure to emerging markets and developed markets. The truth is, you don’t know what is going to outperform tomorrow. But you can be rest assured that investors will always be looking for a place in the stock market to invest their money. As long as money flows in, asset prices will keep going up over the long term.
To summarise, stocks are extremely liquid, which comes with volatility. However, over long periods of time, stock markets are likely to deliver returns outperforming fixed income assets and more importantly, inflation. Deciding how much to allocate to the stock market depends on many factors. You might have heard about the popular 60/40 portfolio (60% in stocks, 40% in bonds), or the revised 80/20 allocation. The allocation is highly personal, and depends on your financial goals and time-horizon. This is definitely a topic worthy of its own article.
5. Alternative Investments
To be honest, alternative Investments comprise a number of asset classes, mainly collectibles and early stage private equity. These asset classes are extremely speculative and carry very high risk. An investment in a start-up may very well go to 0, so diversifying is key as always. Not only that these asset classes carry very high risk, but they also tend to be illiquid in the first few years. An investment in a painting or a start-up may not be easily liquidated for years. Of course, very lucrative returns are expected to justify these investments. Investors in start-ups usually expect to multiply their money on a given investment. That way, one successful company makes up for all the failed ones.
Collectibles include a myriad of items, such as paintings, watches, collectible cards, rare toys, collectible cars etc. Pretty much any item that went out of circulation and has limited supply with a fanbase somewhere. Determining what might end up being valuable is not easy and trends may emerge and die down.
Making alternative investments is very risky, but could be very rewarding. We cannot help much with collectibles, but taking care of collectible items is always a good idea. As for investing in start-ups, we are working on a detailed guide to help you get started. But for now, it is important to note that these investments should not make up more than 10% of your portfolio.
6. Commodities
What does oil, grains and precious metals have in common? That is right, they’re all considered types of this asset class called commodities. We include these here for completeness, but in all honesty, commodities are not easily accessible to investors. It is not very practical to acquire a few barrels of oil to keep for a few years. That is why funds providing exposure to these commodities will usually be invested in derivatives. Derivatives are complicated financially engineered contracts that seldom make retail investor money. We do not mention derivatives here because they do not qualify as assets in our opinion. But you can learn about derivatives here.
Perhaps the most popular asset type in this asset class is precious metals. Gold is widely regarded as an inflation hedge. However, long term returns of gold has not been very supportive of this claim. Especially with the advent of bitcoin, which some view as the new digital gold. Arguably, the best exposure to commodities is via mining and oil & gas stocks. These stocks usually pay a dividend, and may have diversified exposure to the commodities. We don’t think precious metals have a place in a portfolio, unless you admire the lustre of these metals.
7. Crypto Assets
We view cryptocurrencies, crypto tokens and Non-Fungible tokens as an emerging asset class. Crypto assets are young, evolving, growing and unregulated. This creates a speculative environment riddled with scams and misinformation. Crypto assets will have a place in the future, and it is unlikely that democratic, developed economies will ban them like China. However, with that said, cryptocurrencies may very well be the worst asset in this up and coming asset class.
Cryptocurrencies
Cryptocurrencies aim to replace money, in other words, cash. But private money is not a good idea. Decentralised money is not greatly beneficial in a government with a sound monetary and fiscal policy. But most importantly, money needs to be stable and cryptocurrencies are way too volatile to be used as money. We believe this to be the case for all projects aiming to replace money except Bitcoin. Why? Because Bitcoin is a legacy system that could never keep up. If anything, Bitcoin is a collectible. Akin to a rare gold coin from the Roman empire era, Bitcoin is the father of all cryptocurrencies.
Crypto Tokens
The vast majority of crypto projects can be classified as crypto tokens. However, these token have a utility in their ecosystem, and with utility, comes value. For example, the Filecoin protocol allows you to rent out computing storage. To do that, you will need to download the Filecoin client and you will need to pay for this storage in Filecoins. You can see that with adoption and increased use of the Filecoin network, demand for Filecoins will increase due to its utility and so will its price. There are other applications such DApps (decentralised apps), DEX’s (decentralised exchanges), DAOs (decentralised autonomous organisations) that are powered by interesting crypto tokens. We cover all of these and more in a dedicated article here.
NFTs
Finally, NFT’s, or non-fungible tokens. These are collectibles with embedded smart contracts. The smart contract opens up a world of opportunities to the artists and investors. However, tread carefully, these are brand new asset classes, and have been behaving in a bubble-like behaviour recently. Like collectibles, these are speculative risky investments, so don’t put away all your life-savings in NFTs. We would encourage artists and enthusiasts to make NFTs though. Leave us a comment or get in touch if you think a guide on creating NFT’s would help.
Like alternative investments, crypto assets are high risk-high reward. Investing more than 10% of your savings in these assets is risky. But as the best performing asset class in the past decade by a wide margin, you can’t afford not to have some Bitcoin and Ethereum in your portfolio.
Wrap Up
That is it folks. Every asset class you can invest in from the safe to the risky. Best way to preserve and grow wealth is to build a diversified portfolio with exposure to most of these assets. For those of you who are adventerous and want to create wealth from a small amount of savings, don’t be tempted to concentrate on the risky assets here. It is pretty much gambling. Your perception may be distorted by the headlines of crypto millionaires (the availability bias). But trust us when we tell you that far more people lost their money because of their “all-in” mentality. We will update this piece again to reference the detailed guides we are working on for investing in Real Estate, Stocks, Start-ups and cryptos.
Comments are closed.