Want to Get the Most out of Your Investment Portfolio? Diversify it
When most people think of saving and investing they imagine putting money away in a bank account, or maybe buying some shares from their stockbroker. But there are so many more investments out there that could be earning you money.
In the jargon we call these different kids of investment different "asset classes". We'll discuss some of the most widely available asset classes below. But first here's a look at the pluses (and minuses) of widening your investment horizons.
Advantages of Investing in Different Asset Classes
Spreading your assets among different asset classes is one of the few ways you genuinely can reduce your risks without reducing the return you expect to make (most of the time less risk equals less return). Diversification is (almost always) good for your portfolio.
Investing in different asset classes means you are less exposed to the fluctuations of just one or two markets. If you only invest in blue chip USA shares, then if the S&P 500 crashes, your portfolio takes a hit. But if you are invested in other assets that aren't too closely related to share prices, they will be protected (at least, partly) from the crash.
Different asset classes can also offer different cashflow—i.e. when and how you get your returns will vary. Some asset classes like bonds and commercial property are good for regular income. Others like commodities such as gold only return capital gains (the value goes up but it doesn't pay interest or dividends). By picking asset classes with cashflows that meet your requirements you can do much more to tailor your portfolio to your personal needs.
Different asset classes will also have a different mix of income and capital gains in their investment returns. This can be helpful depending on your requirements (growth or current income) and can be useful for tax planning as well—as many countries tax income and capital gains separately.
And, of course, different investors have different investment goals which can need a different mix of income and long term growth. By selecting different asset classes you can build a portfolio that matches your needs.
Disadvantages of Investing in Different Asset Classes
There aren't many downsides as such to diversifying your pot by spreading your investment among different asset classes. But like anything in investing there are potential pitfalls. The worst danger is blindly assuming that any diversifying into new kinds of assets is a good thing without thinking about the assets and the specific investments themselves. Investing in Mediterranean time-share properties might be diversifying but could still be a terrible investment!
In other words you still need to make sure you understand what you are investing in, how it makes money and what potential risks and rewards it comes with. This can be more difficult with more obscure asset classes but don’t worry, there is still a metric ton of information out there. You just need to do your research.
You also need to consider liquidity: how easy it is to turn your assets into spendable cash if you need to. Some assets are very liquid (like blue chip stocks or cash deposits), others are not (like works of Art or residential property).
If there is a chance you will need to cash in investments at short notice make sure you keep enough of your investments in liquid assets. Otherwise there is a risk that you will lose money from having to dispose of assets quickly in a “firesale”.
And remember just because you have diversified doesn’t mean there are no risks. And in some extreme situations like a financial crisis lots of different assets can all fall in value together.
What Asset Classes Are There?
Equities or shares
Equities (also known as oridinary shares or just shares) are a share in ownership of a business. That lets you get a share of the business profits (known as a dividend) and if the business goes up in value you benefit from that too. However if the business goes bust you are likely to lose all or most of your investment.
Preference shares are safer than ordinary shares but they generally only pay a set return, so they are in some ways more like a corporate bond.
Buying a corporate bond is essentially lending money to the big company that issued the bond. Bonds pay regular interest (called coupon payments) and then pay back the money lent at the end of a set term. There is a risk that the issuing company goes bust and can't pay back all of the money lent.
Corporate bonds are usually issued in really big amounts so most retail investors like you and I need to invest via a fund (e.g. a mutual fund or exchange-traded fund).
Bonds are lower risk than equities (when compared like for like) so generally have lower returns.
Government bonds (like US Treasuries or UK gilts)
Government bonds are the same as corporate bonds except they are issued by governments, not companies. Bonds issued by developed countries are very secure as the money will almost certainly be paid back. However, this means that the rate of return is usually very low (because to get low risk you have to accept low returns).
Government bonds from some major economies have particular nicknames such as "Treasuries" (US Government bonds) and "Gilts" (UK Government bonds).
Property (commercial or residential)
Most of us would not be able to buy commercial property outright (although many can afford to buy to let residential property). Fortunately, there are plenty of opportunities to invest in commercial property funds and/or investment companies who make this asset class available to retail investors.
Property tends to have less risk on average than equities but a higher expected return than bonds (ie somewhere between the two).
Commodities are goods that are traded mainly so they can be used, and so they are hard to invest in directly although nowadays investors can buy into a number of specialist funds to do so.
Commodities are split into "softs"—which are things that have a short shelf life like wheat or pork bellies—and "hards"—which are things that last such as iron, silver or gold.
This can include anything from hedge funds to fine art or even fine wine. This kind of investment has often been difficult for retail investors like you and I to get into, but increasingly funds are available to buy which will give you a share in these investments.
These investments are often (but not always) high risk and involve things that can be hard to sell again in a hurry (low liquidity). On the other hand, if you strike it lucky with specialist goods which suddenly become fashionable you can make a lot of money.
Spreading your investments across asset classes does not guarantee you will achieve your investment goals—nothing in investing is guaranteed—but it does give your more tools to manage your portfolio and make it work for you.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2014 Cruncher