What is an asset class?

What are asset classes?

Understanding what an asset class is, and how the main ones differ, is one of the foundations of successful investing. There are several types of asset, or asset classes, but for individual investors the two most important are equities and bonds. Getting to grips with how each works, and the role it plays in a portfolio, is essential before you make any long-term investment decisions.

In this video, you'll learn what each of the major asset classes is and how they behave. When you buy equities (also known as stocks or shares), you are literally buying a small part of a business and becoming a co-owner. Your returns come in two forms: any rise in the share price, and dividends, your share of the company's profits. The trade-off is that if the firm goes bankrupt, shareholders are near the back of the queue of creditors to be repaid. Bonds work differently: here you are lending money, either to a government or, with corporate bonds, to a business, and your returns come from the interest paid on that loan. If the borrower defaults, bondholders sit closer to the front of the queue for repayment.

You'll also learn why equities are considered riskier than bonds, yet have generally delivered higher returns over time, an outperformance known as the equity premium. Because of this, equities should usually form the largest part of a long-term portfolio, especially for younger investors, even though their prices can be volatile. Bonds help dampen that risk, which is why, as a general rule, the older the investor, the larger the proportion of bonds they tend to hold.

The video also covers cash, the safest asset class of all, typically held through savings accounts or money market funds. While it is very unlikely (though not impossible) to lose money in cash, its long-term returns are usually smaller than bonds and far smaller than equities, which is why cash is really for savers rather than investors. Finally, it looks at alternatives, a category that includes property, commodities, hedge funds and private equity, and sometimes even art, classic cars and fine wine, each attractive in its own way but with its own drawbacks.

The takeaway: while you may well want some cash or alternatives in your portfolio, the two asset classes to focus on are equities and bonds. How you balance them is one of the most important decisions you'll make as an investor.

Chapters / Key points

• What an asset class is
• Why equities and bonds matter most for individual investors
• Equities explained: owning part of a business, share price and dividends
• Bonds explained: lending to governments or companies for interest
• Where shareholders and bondholders sit in the queue of creditors
• Why equities are riskier but have delivered the equity premium
• Why age influences the balance between equities and bonds
• Cash: the safest asset class, and why it's for savers not investors
• Alternatives: property, commodities, hedge funds, private equity and more
• Why equities and bonds should be your main focus

Transcript

What is an asset class?

There are several different types of asset, or asset classes. But, for individual investors, the most important are equities and bonds, which in turn are divided into government bonds and corporate bonds.

When you buy equities, otherwise known as stocks or shares, you're literally buying a small part of a business. You become a co-owner of that particular firm. Your returns come in two different forms: first, any increase in the share price, and secondly, dividends, or your share of the profits of the business. If the firm goes bankrupt, as a share owner, you are closer to the end of the line of creditors to be repaid.

When you buy bonds, on the other hand, you're lending money, either to a government agency or, in the case of corporate bonds, to a business. Your returns come from interest paid on your loan. If the business or agency defaults on its bond, you're closer to the front of the line of creditors to be repaid with any remaining capital.

Equities are considered riskier than bonds and have generally delivered higher returns over time. This outperformance is called the equity premium. So, although you must expect 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.

That said, if you invest too much in equities, you run the risk that your portfolio will fall in value far more than you feel comfortable with. For that reason, it makes sense to dampen that risk with bonds. Generally, the older the investor, the larger the proportion of bonds they should have in their portfolio.

The third main asset class is cash. People usually invest in cash either through savings accounts, or so-called money market funds. These are collective investment schemes which either invest your money in cash or equivalents to cash, such as short-term loans to the government. Cash is considered to be the safest asset class of all, as it's very unlikely, though not impossible, that you will actually lose any money. The big downside is that over the long term, cash usually delivers smaller returns than bonds, and far smaller returns than equities. In reality, therefore, cash is for savers rather than investors.

The final asset class, usually called alternatives, principally includes property, commodities, hedge funds and private equity funds. Some would also include in this category art, classic cars and fine wines. All of these alternative investments are attractive in their own way, but they all have disadvantages too.

So, although you may well want to include some cash or alternative investments, or indeed both, in your portfolio, the two asset classes to focus on are equities and bonds.