This is Part 3 of the post series on Getting started in investing. In this post I’m talking about asset classes.
Quick recap: what have we learnt so far in this Investing 101 post series?
In Part 1, I talked about the importance of discovering your WHY when it comes to investing.
Asking yourself WHY you want to start investing is the starting point. Identifying your financial goals, motivations and timeframes for investing. These three inputs all form the backbone of your investment plan.
Read about it here.
In Part 2, I talked about the risk vs return relationship and how you can mitigate investment risk with your portfolio by diversifying your investments across multiple asset classes.
Read about it here.
What exactly is an asset class?
Well, that’s exactly what I wanted to talk about this week.
Asset classes explained
The Australian Investors Association defines an asset class as a category of investments that exhibit similar characteristics in the market place. The investments within a single asset class are expected to have:
- Similar risks and returns
- Be subject to the same laws and regulations
- Perform in a similar manner in particular market conditions
What this basically means is that there are lots of different types of individual investments, and these are all lumped into an overriding ‘asset class’ based on the above factors.
Asset classes are what investors rely upon when determining the make-up of their investment portfolio. They are a starting point for determining portfolio construction (which is a fancy way of saying, what your investment portfolio is made up of).
They will allocate a percentage of funds to different asset classes in order to achieve diversification in their portfolio (which we talked about here). The percentage allocation to each is referred to as ‘weighting’ (which is a fancy way of saying how much is put into each one).
To further explain, a 70% weighting to shares for example, simply means that 70% of the total sum invested is invested into shares. Simple.
Types of asset classes
There are four basic types of asset classes:
- Cash: money in savings, term deposit, in your pocket or under the mattress
- Fixed Interest: money lent to a company or government for interest (certificates of deposit or bonds)
- Property: either direct property (physical ownership) or indirect/listed property (shares in real estate investment trust)
- Shares: owning a share of a listed company
Risk and Return
Each asset class has an expected risk vs return relationship. This diagram from Money Smart illustrates this point for each.
You can see that cash and fixed interest asset classes have a lower risk and lower expected return, while property and shares have higher level of risk and expected return as an asset class.
Investors will typically diversify across asset classes in order to achieve diversification and an overall higher or lower expected return (dependent on how much of their overall funds they allocate to each).
What are asset classes made of??
Within these asset classes there are lots of different types of investment options.
If you are more familiar with investing, you may be aware of things like managed funds, bonds, ETF’s to name a few. These are examples of investment types, NOT asset classes.
And within a particular asset class there are number of investment options and decisions to be made with regards to what type of investment to choose.
Take shares for example, you can have:
- Small vs large cap shares: which refers to the market size of the companies
- Domestic or international shares: which refers to the location of the companies
- Growth vs value shares: which refers to the return potential of the companies
A deep analysis of all these decision is beyond the scope of this post but it’s important to understand what an asset class is and then the difference between an asset class and investment types.
Putting it all together
Last week we spoke about risk and the importance of understanding where you sit on the risk curve.
This becomes important in the context of determining your individual asset allocation.
If you are a more conservative investor, when looking to invest, you should consider a more conservative asset allocation. This kind of portfolio would generally have more funds invested in cash and fixed interest investments.
If you are a more aggressive investor, you would consider a more growth orientated portfolio, which would generally have more funds invested in property and shares.
The following diagram illustrates this point.
An aggressive portfolio (higher risk, potential for higher returns) has more growth orientated investments in the portfolio (e.g. property and shares) while the more conservative portfolio (lower risk, lower expected returns) has more defensive investments in the portfolio (e.g. cash and fixed interest).
Step by step – what we’ve covered so far
Let’s take a look at the decision making process we’ve covered with this post series so far, in getting started with investing:
Step1 [Covered in Part1]
Write out your investment goals. Clarify WHY you are investing and identify your motivation for sticking with it.
Step 2 [Covered in Part 1]
Determine your investment time horizon – by when will you need access to your funds to meet your investment goals (e.g. 2 years, 5 years, 15 years)
Step 3 [Covered in Part 2]
Determine what kind of investor you are; how comfortable are you with taking investment risk? Are you an aggressive investor, a balanced investor or perhaps a conservative investor?
Step 4 [Covered in Part 3]
What type of asset allocation are you best suited to based on your investment time frame and risk profile.
But that’s not the full story – there are a couple more steps which I will cover in the next TWO posts in this series.
Here’s a sneak peek:
[yellowbox]What kind of investor are you: a passive or active investor (and what that all means?)[/yellowbox]
[yellowbox]Choosing investment types: what kinds of investments suit different investment timeframes, risk profiles and active vs passive management.[/yellowbox]
Until next time