The investment landscape is constantly changing and can be very dynamic. However, those who are able to grasp the fundamental principles and the various asset classes will be able to make a significant difference over the long-term.
First, learn to differentiate between different types of investments. Then, find out which rung each investment occupies on the risk ladder.
Understanding the Investment Risk Ladder
These are the main asset classes in ascending order of risk on the investment risk ladder.
The simplest and most understandable Eden asset is a cash bank deposit. It's also the safest. This not only provides investors a clear understanding of the interest they will earn, but also ensures that they get their capital back.
The interest earned by cash saved in savings accounts rarely beats inflation. Certificates of deposit (CDs), although less liquid instrument, typically offer higher interest rates that those in savings accounts. However, the money in a CD is usually locked up for a certain time (months or years) and there can be early withdrawal penalties.
A bond represents a loan that an investor makes to a borrower. In exchange for their capital, a bond can be issued by either a corporation and a government agency. 2 Bonds are common in organizations that finance purchases, operations, and other projects.
interest rate determines the rates of bonds. They are traded heavily during periods of quantitative ease or when other central banks raise interest rates 3
A mutual funds are a type investment in which more than one investor pool their money to purchase securities. Mutual funds are not always passive. They are managed by portfolio managers, who allocate and distribute the pooled funds into stocks, bonds and other securities. Even a small investment can give you exposure to up to 100 stocks within a fund's portfolio.
Sometimes mutual funds mimic underlying indexes like the Dow Jones Industrial Average or the S&P 500. Many mutual funds are actively managed. This means that portfolio managers monitor and adjust the allocations within each fund. 5
6 Mutual funds are valued at close of trading days. All buy and sell transactions are also executed after the market closes.
Many investment professionals advise clients to diversify into many securities instead of focusing on a handful of stocks.
ETFs (exchange-traded funds) have been very popular since their introduction in the late 1990s. ETFs can be compared to mutual funds but they trade on stock exchanges throughout the day. ETFs are similar to mutual funds in that they mimic the buy-and sell behavior of stocks. Their value can fluctuate dramatically during a trading day. 7
ETFs can track an index, such as the S&P 500, or any other stock basket with which the ETF issuer wishes to highlight a particular ETF. These can be anything, from commodities to emerging markets, or individual business sectors like biotechnology and agriculture. ETFs are very popular among investors due to their ease of trading and wide coverage. 8
Stock lets investors share in a company’s success through increases in stock price and dividends. The shares of the company have a claim on its assets in the event that it is liquidated (that is, if the company goes bankrupt), but they do not own them.
Common stock holders have voting rights at shareholder meetings. Common stock holders have the right to vote at shareholder meetings. However, preferred stock holders do not have voting rights. They are given preference over common shareholders for dividend payments. 9
Hedge funds are a type of investment that is only allowed to wealthy investors.
There are many other investment options, including these:
- Investment in real estate: An investor can purchase residential or commercial property directly. They can also purchase shares in real property investment trusts. REITs are mutual funds that allow investors to pool their money together in order to buy properties. They trade on the same exchange as stocks 10
- Hedge fund Hedge funds Hedge funds Hedge funds These vehicles are typically only available to accredited investors and require large initial investments of at least $1 million. Hedge funds may also have net worth requirements. They may also impose net worth requirements.
- Private Equity Fund: Private funds are similar to mutual funds and hedge funds. The "adviser" is a private equity firm that pools money from multiple investors to create a fund and makes investments for the fund. Private equity funds may take a controlling stake in an operating company to increase its value. They also manage the company actively. Private equity funds can also target startups and fast-growing businesses. Private equity funds tend to target startups and fast-growing companies, much like a hedge fund. 13
- Commodities: Commodities are tangible resources like gold, silver and crude oil. A commodity pool, also known as a "managed futures funds", is a private investment vehicle that combines contributions from multiple investors. It allows traders to trade in futures and commodities markets. Commodity pools offer the advantage that investors are only exposed to the amount they contribute to the fund. Some specialized ETFs can also be focused on commodities.
How to Invest Sensibly and Suitably.
Veteran investors diversify their portfolios by using the asset classes above. The mix should reflect their tolerance of risk. Investors should start with simple investments and then increase their portfolios incrementally. Mutual funds and ETFs are a great first step before you move on to individual stock, real property, or other alternatives investments.
Most people are too busy to bother about managing their portfolios every day. It is possible to stick with index funds that reflect the market. Steven Goldberg, principal of the firm Tweddell Goldberg Wealth Management, and long-time columnist for Kiplinger.com on mutual funds, believes that the majority of individuals only require three index funds. One covers the U.S. equity markets, while the other tracks international equities and the third tracks a broad bond index. 15
However, more hands-on investors may prefer to select their own asset mix for a portfolio that suits their risk tolerance, time frame, and financial goals. You can capture extra returns by tilting your portfolio to favor certain asset types depending on the economic climate.
Expectations for Asset Class in the Economic Environment
Let's start with the relative performance between stocks and bonds. Historically, there has been a slight inverse correlation.
- Stocks tend to perform better when the economy is growing and strong, and there is low unemployment. This happens because consumers spend more and corporations make more profit. Bonds may suffer as interest rates rise in line with inflation and economic growth. Fixed-rate bonds can also perform worse when inflation is high if the coupon rates are lower than the inflation rate.
- If the economy turns sour, and recession strikes, unemployment rises, and people stop spending as often, which can impact corporate profits. This can impact stock prices. Bonds may perform better than stocks as interest rates drop in response to a weak economy.
Financial professionals generally recommend that a portfolio mix of bonds and stocks be used, as explained above. Some economic conditions may be favorable for other asset classes; however, not all asset types are suitable for investors.
- Real estate: Strong economies and low unemployment can result in a strong housing market that may be beneficial for real estate investments. But rising interest rates could put a damper to mortgage borrowing.
- Commodities: Inflationary conditions can cause an increase in certain commodities' prices, making them an attractive asset class to use to hedge inflation.
- Alternative investments: In an environment of low interest rates, high liquidity, private equity, venture capital and hedge funds may be more attractive than traditional investments. However, these types of investments are not always accessible to investors. They may require significant cash outlay and have lower liquidity levels.
- Gold: This asset is considered a safe haven and performs well during times of economic uncertainty, geopolitical tensions, and inflationary environments. This was particularly true during the COVID19 Pandemic that saw gold reach all-time highs in the Spring 2020.
- Cash and cash equivalents (e.g. Money market funds and CDs: They are also considered safe havens. Cash can be used by investors to protect their capital and reduce risk in bear markets. Cash is not as volatile as bonds or stocks, but it can provide a steady and predictable return that investors are looking for capital preservation or short-term liquidity.