Lesson 1: What are the main asset classes?

‘Asset class’ is a term that describes groups of securities that act similarly in the marketplace.

There are several different asset classes, but for individual investors, the most important are equities – otherwise known as stocks and shares – and bonds, which are often divided into government bonds and corporate bonds.

When you buy equities, you are literally buying part of a business, and becoming a co-owner, or shareholder, of that particular firm.

The returns you get come in two forms. Firstly, any increase in the share price, making your investment more valuable; and secondly, dividends, which are your share of the profits the business makes.

But if the firm goes bankrupt, as a shareholder, you’re close to the end of the line when it comes to being repaid.

When you buy bonds, however, you’re lending money, either to a government agency, if it’s a government bond; or to a business, in the case of corporate bonds.

Your returns come in the form of interest you receive on your loan.

If the business or agency defaults on its bond, you’ll be a bit closer to the front of the queue to be paid from any capital remaining.

Equities are considered riskier than bonds but, on the other hand, they generally deliver higher returns over time.

So, although you should expect share prices to be volatile at times, equities should, in most cases, form the largest part of a long-term investment portfolio, especially for younger investors.

However, if you put too much into equities, you run the risk that your portfolio could fall in value more than you feel comfortable with. So it makes sense to dampen the portfolio volatility with bonds.

This is why, the older you are, the greater the proportion of bonds in your portfolio should be – because you have less time remaining to make up the potential shortfall from share losses.

The third main asset class is cash.

People usually invest in cash via savings accounts or so-called money market funds. These are collective investment schemes where your money is invested alongside other people’s money in cash, or cash equivalents such as short-term government loans, known as treasury bills.

Cash is considered to be the safest asset class of all, as it’s unlikely, although not impossible, that you will lose any money.

The downside to this safety is that over the long term, cash usually delivers smaller returns than bonds – and considerably smaller returns than equities. Cash also carries the risk of having it’s purchasing power eroded by inflation.

In reality, therefore, cash is for savers, rather than investors.

Finally, there are alternative investments – which include property, commodities, hedge funds and private equity funds. Some people also include art, classic cars and fine wines in this category. They all have their attractions, and disadvantages.

You may want to include cash or alternatives, or both, in your portfolio, but the two main asset classes you should focus on are equities and bonds.