Asset classes are defined as groups of investments which have similar characteristics and behave in a similar way. Equities (stocks and shares) are one of the most famous asset classes, but there are also 8 others which I’ll cover in this overview of asset classes.
Asset classes are the raw ingredients for an investment portfolio. How you decide to blend together these different types of investments will determine the expected return, the risk and the liquidity profile of your holdings.
If done skillfully, complementary asset classes can actually reduce the total risk of your portfolio. This is the holy grail of portfolio management.
In this overview of asset classes, I will introduce each key asset class and explain both its key characteristics, and explain why an investor might choose to invest in them.
This article is not financial advice, please consider finding an independent financial adviser if you seek professional guidance.
Asset classes – an overview
A high level overview of the asset classes
At the most basic level, you can divide all investment opportunities into three groups:
- Equity investments – Partial ownership of a business through being a shareholder
- Fixed income investments – Loans or cash deposits made to businesses, governments or individuals
- Property – Ownership of buildings or land, for the purposes of speculation on prices or the collection of net rental income.
- Other investments – Position which represent neither of the above.
There’s a specific reason why I like to carve up the asset classes into this very high level grouping before listing out each individual asset class. It’s because I want to emphasise the importance of equities, fixed income and property investments above all others.
If you were to combine every pension scheme and investment portfolio of every investor worldwide – I can guarantee you that 95%+ of the investments would belong to these three main categories.
Equities and bonds, in varying proportions, are the core holdings of virtually every retail investment portfolio.
While the ‘other’ category is home to some asset classes with high expected returns and unique characteristics, I wouldn’t want to suggest that these are in some way desirable compared to equities and bonds.
An overview of each asset class
For each asset class in bold, I will provide a brief explanation of the risks, the rewards, the liquidity characteristics and give an indication of an appropriate minimum time horizon to hold each investment.
I’ll also point out some of the key sub-asset classes which exist and how they differ.
- Common shares
- Preference shares
- Emerging market equities
- Fixed income
- Cash deposits / savings accounts
- Government bonds
- Corporate bonds
- Land, including forestry
- Residential property
- Commercial property
- Industrial property
- Precious metals
- Hedge funds
- Long / short funds
- Global Macro funds
- High frequency trading
- Venture capital
- Private investments
- Venture capital trusts
10. Structured Products
1. Equities as an Asset Class
Equities represent a partial ownership stake in a real business. (More: What are shares?)
Shares can technically have different conditions attached, which provide shareholders with different risks and rewards, but these are generally grouped into two categories:
- Common shares – These are the dominant type of equity class and are what investors are generally referring to when they refer to ‘shares’ without any further clarification.
- Preference shares – An uncommon form of share which grants its owner a higher priority over common shares when collecting dividends, or cash upon liquidation of the business. Some preference shares entitle their holder to a fixed interest payment, which makes them feel more like a bond than a common share.
I’ll describe the characteristics of common shares from this point onwards.
Reward – equities
A shareholder is entitled to their share of the profits, and total assets and liabilities of a company. In practice, each time a company declares distribution of profits to shareholders, each share will earn its holder a cash payment, which will be automated routed through to shareholders’ stockbroker account.
Dividends are paid at the discretion of management, and some companies don’t pay dividends at all, opting to reinvest the cash invested back into the business to generate higher growth in revenues and profit. The idea behind this is that a larger and more profitable company will be in a position to pay even larger dividends in the future, so this can be a worthwhile trade-off.
If a company’s prospects and dividends have grown over time, the price per share on the stock market will have also likely increased. A shareholder can choose at any time to sell their shares and realise a gain or loss on that investment depending on how the price has moved whilst in the investors portfolio.
Risk – equities
Of all the groups that provide finance to a company, shareholders carry the most risk.
Firstly, in the event of a bankruptcy, all other parties (including employees, suppliers, the tax authority and lenders) must be repaid in full before any cash is distributed back to shareholders. In practice, this leads to a total loss in the event of a collapse, as struggling businesses usually have insufficient reserves to cover all of the amounts that they owe.
Secondly, an investor who buys shares will experience ups and downs in the form of volatility in the share price. The prices of shares do not move in a steady trend. They gyrate quite significantly in an apparently random fashion over the short term.
This is the impact of shareholders and potential buyers in the market continually reassessing the value of the company in light of the most recent news and economic data.
This price risk is most apparent during economic crises when the perceived value of businesses falls substantially in a short period. Investors holding a basket of shares have been known to experience up to 60% losses in the space of 12 months during these periods.
That being said, the stock market has always historically recovered from such stock market crashes, and therefore this is an asset class which provides a more predictable reward over the very long term, such as 5 or more years.
Liquidity – equities
Shares in companies which are publicly traded on the world’s stock exchanges with the help of stockbrokers are a very liquid investment. Liquidity refers to the ability of an investor to convert their investment into cash in a short space of time.
Even during economic crises, investors can expect to find a buyer for the shares of major companies with relative ease during the trading hours of the stock exchange.
Once a trade is made, a share can be converted to cash within 2-3 days, which is the time it takes for the trade to be fully documented and for the cash to be exchanged between buyer and seller through an automated process known as a settlement.
Read more: The best stocks & shares books for beginners
Emerging market equities
Investors tend to allocate most of their equity investments to large and mature businesses which are listed in the stock exchanges of highly developed economies, such as those of Europe, North America and Japan. Today, these exchanges account for over 75% of the world’s traded companies by value.
However, investors may decide to purposefully allocate a portion of their equity investments to businesses which are based in, and heavily exposed to high growth economies known as ‘emerging markets’.
The emerging markets include China, India and Brazil. As the economies of these countries have experienced a far higher rate of economic growth and technological development, it follows that their business will also experience a higher rate of growth. This has been proven correct over the last two decades.
However, investing in emerging markets carries an additional level of risk, including political and social instability, lighter regulations, and less effective rule of law. This translates to even higher volatility in share prices.
Having risen from $11 in 2003 to $54 by 2007, the MSCI Index (which measures the prices of a basket of large emerging market companies), had crashed back down to $19.82 one year later. It now trades at $43 at the date of writing this article in 2020.
Read more: Investing in emerging markets
2. Fixed income as an asset class
Bonds are a form of loan agreement, which can be traded between owners, known as bondholders.
Bonds therefore share similarities with a fixed term savings account with a few key differences which we’ll cover in the following section.
You may have noticed above that I officially included cash in the fixed income asset class, as a bank account provides a fixed income in the form of an interest rate.
Other observers prefer to put cash in its own asset class due to its complete simplicity. I don’t mind either approach. I won’t expand upon cash as an asset class in this guide, as I’ll assume that you’re already familiar with the low risk and instant accessibility of a simple bank account.
Reward – fixed income
Whoever owns a bond will be entitled to receive scheduled interest payments (known as coupons) and in most cases the full repayment of the lump sum amount (known as the ‘principal amount’) at the maturity date.
A bond has a market value, which fluctuates over time just like a share. A bond represents a series of semi-risky cash inflows which should occur over a fixed period of time. Due to changes in the creditworthiness of a company, the availability of interest rates elsewhere, or general economic conditions, the value that market participants will be prepared to pay for this series of cash flows will naturally change over time.
This means that a bondholder can receive income from the bond, but also experience a gain on the value of the bond itself over time.
It’s important for you to understand that despite this fluctuation in market value which can occur during a bond’s life, the nominal value of the coupon payments and final repayment will not change. Therefore, if a bond is held until maturity, and the company does not collapse, then the maximum return is effectively fixed. This rate is known as the Yield to Maturity, or YTM for short.
Read more: What is a bond coupon rate?
Risk – fixed income
The key risk for a bondholder is credit risk. This is the risk that the business struggles and is unable to repay the coupon or principal of a bond. If the business eventually files for bankruptcy, it is unlikely that a bondholder will receive much compensation from the subsequent liquidation process, although they may receive a small fraction of the bonds face value.
Bonds typically have no ‘security’ or ‘collateral’ which can be specifically sold to repay the investors. They are a form of unsecured debt, which makes them more risky than secured loans, such as mortgages. Credit rating agencies often provide a credit score for each large bond issuer which helps to inform a potential investor about the financial stability of a company.
It is worth pointing out that bondholders need to be repaid in full before a shareholder receives a single penny. Bonds rank as a more senior claim in the order of liquidation.
Another key risk for bondholders is that the interest rates of other investments rise. This could be due to a shortage of money supply in the economy, a change in central bank rates, or new bonds being issued with a more attractive rate.
Rising interest rates are bad news for a bondholder, because the YTM on a bond is fixed. The market will place a lower value upon it if more attractive rates become available. For this reason, bond prices always move in the opposite direction to interest rates.
Liquidity – fixed income
A bond can be easily sold to another party for cash, unlike a fixed term bank account which might commit you to keeping your money in there for a fixed period.
Do investors directly invest in bonds?
In practice, rarely do retail investors invest directly in bonds. This is because the minimum trade size in the bond market is high, e.g. £5,000. This makes it prohibitively expensive to diversify across a portfolio of 20 bonds or more.
What virtually all investors do instead is to buy units of a collective investment vehicle such as a mutual fund, a unit trust, an open-ended investment company, or an exchange-traded fund, which in turn will pool the money of other investors and purchase bonds of a particular description.
Most bond funds will distribute the coupon receipts to unit holders by way of a dividend, which provides a very similar investment experience almost as if the investor had bought the collection of bonds themselves.
Corporate bonds versus government bonds
Up until now, I have described bonds in generic terms. When constructing a portfolio, investors usually separate this asset class into two main parts; corporate bonds (bonds issued by companies), and government bonds (bonds issued by central government). There are also municipal bonds, which are issued by local authorities, but these are uncommon.
Corporate and government bonds work mechanically in identical fashion. The key distinguishing feature is that a government can often provide absolute assurance that the bond will be repaid.
In contrast, the management of a company can do their utmost to govern responsibly but they cannot provide a 100% assurance that the company will not suffer an unforeseen event and fail.
Why are we so confident that governments can repay? The most important reason is that a government typically issues bonds denominated in their domestic currency. The UK government, for example, will typically issue bonds in Pound Sterling.
In the event of any shortage of funds, investors understand that the UK government can always ‘print more money’ to make the payments. Sure, this will potentially reduce the value of the currency, but the bondholders will see their promised return.
History has shown that this isn’t always the case – some governments in the past have actually defaulted. Members of this unfortunate club include Russia and Argentina. But in general, democratically elected and stable countries which responsibly control their own currency are one of the least risky investments that exist.
So why do we care about this difference in risk between corporate and government bonds? It’s because investors are prepared to accept a much lower rate of return if it is more certain.
As a result, government bonds have a very high valuation relative to their coupon payments. This means that their YTM is very low – often below 1%.
Despite these low rates of return, government bonds are still a popular asset class, favoured by pension funds and insurers who wanted a high degree of certainty over investment returns over super long periods. Even retail investors tend to allocate some of their fixed income asset allocation to government bonds to bring the risk level of the overall category down.
Read more: The best asset allocation books.
There’s also a second reason why government bonds are too useful to ignore. During a financial crisis, investors and their capital tends to fly away from risk assets (equities, property) and into safe havens such as government bonds. This leads to government bonds appreciated in value while other asset classes plunge by double digit percentages.
Government bonds (and corporate bonds regarded as the highest of quality) therefore can act like a stabilizer in an investment portfolio, helping to protect it from the worst of the stock market.
3. Property as an asset class
Property is an asset class which tends to split the investing community. Some investors love investing in property and access the asset class through various means. Other investors eschew property altogether and focus on equities and bonds.
A common criticism thrown at bricks and mortar is that many investors already feel over-exposed to property. Why? Because they usually spent far more money than they wanted on a single property – their own home!
I personally argue that a property shouldn’t be counted as part of your investment portfolio, however to those who keep an eager tab on the valuation of their house, it may feel a little too much to begin adding more property investments into a retirement pot as well. I have sympathy with that view.
To a younger investor, the opposite might apply. If you’re planning on saving for a house over a long period (e.g. 5+ years), then adding property to your portfolio could act as a useful hedge against house prices racing upwards while you’re saving up for a deposit.
If house prices rise, your investment portfolio should grow faster too, helping you to keep pace as the deposit bar is raised. Like the rest of this article, this is only a general observation and not a specific recommendation.
Reward – property
Property investments provide a return in two main forms:
- Rental income
- Capital appreciation
Rental income and capital appreciation are very different investment objectives. Rental income is earned by letting the property to a short-term tenant over a period of time.
Capital appreciation is only realised as a cash gain when a property is sold – typically after enhancing its value through development, extensions or redecoration.
Investing in land is seen as more speculative, because an unused parcel of land does not generate rental income.
Risk – property
Property ownership brings several risks:
As a landlord, you may be drawn into issues with troublesome tenants, damage (accidental or otherwise), void periods and the mountains of red tape and an unfriendly tax regime.
It can be difficult to ‘diversify’ yourself as a landlord, due to the fact that you may not be able to afford to own more than one investment property to begin with.
As an investor in property development companies, your investments could lose significant value in a downturn. The market value of British Land, a diversified Real Estate Investment Trust (REIT) lost two-thirds of its value during the financial crisis which began in 2007.
The common phrase ‘as safe as houses’ conveys a sense that the property asset class has a degree of security which others do not. This paints a misleading picture. If you look at our UK real house price graph, you’ll see that at the time of writing, UK house prices have actually not yet recovered to the pre 2007 price level when inflation is taken into account.
Liquidity – property
Property is very difficult to transfer between two parties, owing to the multitude of factors that make each property unique.
Banks, surveyors, conveyance solicitors and sometimes planning permission departments in councils will sometimes all need to be involved to simply let a single house change hands. This can lead to orderly house sales taking between 2 – 6 months to fully complete.
High transaction costs, such as UK stamp duty and estate agents fees can be in excess of 5% of the property value, which further discourages trade.
Properties can be sold expediently to ‘house buying companies’ or through auctions, however this speed will come at the expense of not achieving the full market price. House buying companies need to make a profit margin on the resale of the property, and auction bidders will discount the property to cover unidentified risks or issues which may need remediation.
Other asset classes
We now leave the major asset classes behind and find ourselves in more exotic territory.
Commodities and the remaining asset classes are optional components of an investment portfolio.
Each of these ‘other’ asset classes are primarily used by sophisticated investors. They tend to have at least one of the following characteristics:
- Extreme price volatility – capable of falling in value by 70%
- Low or neutral expected returns – a lack of basis for future growth
- A very illiquid market – few buyers or sellers
- High minimum investments – due to market rules or high transaction costs
However, you will also find that each asset class has a redeeming feature which makes it attractive to some adventurous investors with a high risk appetite. There can be a rationale case for including these asset classes in a portfolio in sensible amounts, despite their drawbacks.
4. Commodities as an asset class
A commodity is a standardised resource which is used in the economy. Examples of commodities include oil, gas, timber, gold and wool. You can find a full list of commodities here.
Commodities are sought after by manufacturers, who typically use them as raw materials in their production processes.
Like any good, the price of commodities are set by the market, as a function of supply and demand. Their prices will fluctuate due to changes in industrial demand, demographics, supply constraints or seasonality.
These price fluctuations attract speculators who see an opportunity to make a profit by buying low and selling high.
It would be highly inconvenient to take deliveries of large quantities of real commodities. This is why a wide range of financial instruments exist which allow investors to gain exposure to the price of commodities without needing to open a warehouse!
Reward – commodities
An investor takes a long position in a commodity if they think the price will rise. It’s possible to also take a short position through contracts known as derivatives, to allow them to profit if the price falls.
A key issue is that commodities have uncertain expected returns. Unlike equities or bonds, which are financially engineered to provide a reasonable return to investors, commodities are nothing more than an inanimate object.
A lump of coal does not naturally ‘grow’ over time, and nor is there any guarantee that it will hold its value. Indeed, depending on technological progress, it’s possible that certain commodities will become obsolete and almost worthless.
On the other hand, supply constraints can justify an optimistic view on other commodities. Investors in precious metals, for example, have some protection in the knowledge that precious metals are generally finite, rare, and expensive to extract. This reduces the likelihood that the market could suddenly be flooded with precious metals.
Risk – commodities
An investor in commodities is exposed to a fall in the value of a commodity they own, or a fall in the value of a derivative contract which is linked to the price of a commodity.
The gold price per troy ounce in 1980 was around £235. By 2005, 25 years later, it was still roughly the same price. Due to the effects of inflation, this equated to a significant loss for any investor who had invested in gold during that period.
Since then, the gold price peaked at around £1,100 in 2011, before falling to £700 in 2015, and reaching a historical high of £1,500 in 2020.
This long term picture of gold paints a very inconsistent picture. Even over an extremely long time horizon, there can be little assurance taken that gold will deliver a gain in real terms.
Silver has had an even choppier time. It also languished over the 25 year period since 1985, before increasing tenfold in 2011, before crashing by 66%.
As a significant part of an investment portfolio, a silver investment would have disappointed for a long period, then produced an extremely high return in the space of two years, before giving away most of those gains.
Investors are also exposed to a security risk if they decide to invest in gold by purchasing gold bullion bars or coins. Insurance and security measures are essential to provide peace of mind.
A final risk worth highlighting is the counterparty risk of entering into derivatives. Many investors use derivatives or invest into fund which in turn use derivatives. Derivatives are a contract between two parties, and therefore the risk of that counterparty defaulting on their obligations is always present.
Liquidity – commodities
The liquidity of a commodity investment varies depending on the method used to invest.
Derivatives can be freely traded over the counter with the bank who issued them, or potentially other market participants.
Shares in collective commodity investment schemes such as Exchange Traded Funds or Exchange Traded Notes can be bought or sold quickly like equities.
Physical commodities are less liquid, as you will need to manually find a buyer and fulfil a sale. However, there is usually an active market for investment-grade commodities because they are standardised, e.g. gold bars, gold coins, which have a minimum level of purity.
Read more: How to invest in commodities
5. Hedge funds as an asset class
Many people view hedge funds as expensive or exotic variations on an ordinary mutual fund, therefore they are surprised to see hedge funds listed as an independent asset class.
The reason they are often labelled separately is because of the way they generate their gains and losses.
Reward – hedge funds
Hedge funds use a number of different investment strategies, as I explain in my guide to hedge funds.
- Long / short
- Global Macro
- High frequency trading
What these strategies have in common, is that they don’t seek to simply capture the market return, known as beta.
Ordinary mutual funds will invest in a diversified basket of equities or bonds. In doing so, they will be exposed to the risks of those individual companies, but also the overall market. If there’s a large market crash – it won’t matter which companies they picked – their fund will almost inevitably fall too.
Hedge funds work differently. They try to find profits which are unconnected to the general rise in prices over time.
Hedge funds will own assets such as equities, but they get their name from the way that they often sell equities too. By taking a short position in some equities whilst backing others, they aim to keep a neutral exposure to overall market trends, allowing them to extract the specific gains that they are targeting.
The upshot of this approach is that hedge funds are designed to have a lower correlation with the overall stock market. This quality is what earns them their own category. When added to a portfolio, the right hedge funds could help to reduce volatility.
Risk – hedge funds
Hedge funds are far less regulated than UCITS funds such as standard Exchange Traded Funds. This allows hedge funds to engage in the highly speculative and risky investment activities that their prospectus promises.
Hedge funds are also allowed to borrow heavily to ‘leverage’ bets they make, in an effort to fully take advantage of opportunities they find.
Their holdings may be undiversified, and their strategies may stop working, or even backfire altogether.
Hedge funds require more manpower and depend upon recruiting the best and brightest individuals in the jobs market to design new strategies, which leads to high investment costs which will erode their returns.
A common misconception about hedge funds is that they are a very high-performing group of funds. The truth is that many hedge funds fail to beat the market return of a simple cheap equity ETF.
However, remembering that their primary purpose is to achieve a lower correlation with the stock market, rather than a high absolute return, many private and institutional investors still believe that hedge funds have earned a place in investment portfolios.
Liquidity – hedge funds
The liquidity of hedge funds can vary. Some funds only open their doors to new investment on a periodic basis, and require all investors to remain invested until the next trading window, which can be years at a time. This gives the fund manager the ability to make illiquid or long term investments without the risk that withdrawals will make it necessary to sell assets at fire sale prices to be able to pay them back.
For similar reasons, hedge funds occasionally prohibit withdrawals during periods of depressed asset prices or poor liquidity.
6. Venture Capital as an Asset Class
Venture capital is a type of private investment in the shares of unlisted businesses.
This is similar, but separate from private equity, which is where an investor takes a controlling stake in a firm and is involved in its management and strategic direction. (Read more: private equity books).
Investors can participate in this investment activity by either making a large direct investment into a company during a funding round or by investing in a Venture Capital fund, such as a Venture Capital Trust (VCT).
Reward – venture capital
A VCT will pool investor monies and invest in a variety of small to medium sized businesses. Businesses of this nature have higher risks but also higher rewards.
While a large corporation might aim to increase its revenue by 10% per year, a medium sized business could feasibly double its revenues each year for an extended period, which could result in a significant increase in value for the investor.
An investor in private businesses is unlikely to see any form of return until their stake is sold to another party, or if the company participates in an Initial Public Offering (IPO). By listing its shares on a stock exchange through an IPO, this provides an exit route for the original investors. Proceeds could be then reinvested back into several newer, smaller businesses.
A VCT will be highly selective, and will usually only invest in businesses which allow it to qualify for a generous tax break to the investors. This tax break has the effect of paying a 30% ‘cashback’ rate to investors on their original contribution.
Risk – venture capital
Investing in small business carries a real risk of total loss, as small businesses regularly fail and shut down completely. The Telegraph reports that 60% of new British companies will fail within the first 3 years.
It is for this reason that private investors prefer to invest in VCTs which provide a small degree of diversification across several businesses.
Small businesses tend to be more sensitive to economic downturns, and a tightening of the financial markets, as they may incur losses as they grow, and are reliant upon regular capital raising to continue to fuel their growth towards sustainable profitability. This means that even the top venture capital trusts can provide a bumpy road for investors, as any comparison of UK VCT performance will demonstrate.
Liquidity – venture capital
Liquidity of small company equity investments is virtually nil. It is very difficult for a shareholder to find a willing buy for their shares, particularly because the second-hand transaction will not offer a buyer the same tax incentive as when investing through a VCT.
A venture capital investor will not usually have sufficient shares to be able to directly control a company’s actions. Therefore they become back seat drivers in a roller coaster which they hope will end in a successful exit transaction.
Read more about venture capital with our ranking of the best venture capital trust books to learn more about the venture capital industry in general.
Read more: The best venture capital books
7. Currencies as an asset class
Currencies are effectively a financial asset, which can increase or decrease in value relative to other currencies.
The value of a currency can be affected by many factors, including domestic interest rates, economic growth and flows of trade and capital between countries. The list is endless.
The fluctuating value of currencies provides speculators with an opportunity to make money by trading forex.
Risk & rewards – currencies
An investor buys currencies in the hope that they will appreciate in value against the investors domestic currency. When the investor converts the currency back into their own domestic currency, they will see a profit.
Currencies have a poor investment case for long term growth. Unlike the stock market, or even the commodities market, it is not possible for the entire market to rise in value.
Currency is a unit of exchange, and not a real asset in itself. Even if the size of the global economy grows, this doesn’t mean that each of its currencies will appreciate in value.
This is because currency is priced in pairs – the price of one currency is set relative to another. If the value of both increases… the conversion rate will still remain the same, so an investor has made no gain on paper.
Investors therefore only capture a gain if they choose the right side when a swing in value occurs from one currency to another. However for each investor that wins, another will lose.
This is why currencies are not found in traditional investment portfolios as a simple long term holding. They have an expected return of nil, therefore they will act as a drag on performance.
Currencies are only held by speculators who day trade (take short term positions) and believe they can ‘beat the market’ and extract a profit from a zero-sum scenario.
Read more: How to trade forex
8. Cryptocurrencies as an asset class
Cryptocurrencies are a subset of currency but deserve a separate consideration.
Cryptocurrencies are digitally managed, which are often managed in a decentralised manner using a technology known as blockchain.
A cryptocurrency’s integrity is assured by encryption protocols and distributed ledgers, which effectively means that many market participants all hold a record of every historic transaction, which makes a transaction effectively permanent and impossible to reverse.
Rewards – cryptocurrencies
The rewards for investing in cryptocurrencies have been capital gains in the value of that currency.
Bitcoin is the most well known cryptocurrency. The exchange rate for a bitcoin began in 2009 at less than a cent, but this has grown to over $1,000. This has resulted in millions and even bitcoin billions being created.
Each cryptocurrency works in a slightly different way, owing to a different organisation or protocol which governs how the currency is mechanically processed and how new units of the currency are created.
A key distinction between bitcoin and traditional fiat currency like Pound sterling is that the core design of bitcoin only allows for a finite number of bitcoins to ever be created. This is in stark contrast to the money supply of the pound, which is expanded by the Bank of England as needed, to meet the theoretical demand for cash in the economy.
This finite supply has led to speculative interest in the value of a bitcoin, as (like land) its value can apparently only ever increase if demand continues to rise.
Risks – cryptocurrencies
The meteoric price increases have so far proven this supply & demand logic, but there are still huge downside risks.
While supply is fixed, future increases in demand are not certain. Cryptocurrencies are not an integral part of the world’s financial system and could yet be outlawed or rendered obsolete – a development could cause the value of a bitcoin to return once again to < 1c.
While the supply of a bitcoin is fixed, there is no limit on the number of competing cryptocurrencies. The abundance of alternatives places a large question mark over whether bitcoin’s price should behave as if the supply is fixed.
There is no way to determine the inherent value of cryptocurrency. This, combined with the feverish speculation in the currency, results in a very volatile price which makes cryptocurrencies inappropriate for all but the most adventurous investor.
Read more: Is Bitcoin the Investment of the Future?
9. Collectables as an asset class
Collectables represent any objects that tend to hold their value over time. This asset class includes pieces of art, antique furniture, classic cars, vintage wines and sci-fi memorabilia.
Rewards – collectables
Investors in collectibles have often seen excellent returns exceeding 10% per year. A burgeoning middle class worldwide is leading to steadily increasing demand for the finer things in life. And the ultimate status symbol is a limited run item which ‘they no longer make like they used to’.
As this demand for wine, classic cars increases, those who are lucky enough to own some of these limited edition pieces will find that the market value of this will also increase.
Capital gains on collectible items are often realised at auction houses, where niche items can be sold nationally or even internationally to the highest buyer.
Risks – collectables
The market for collectables is a fickle one indeed. Some products carry an almost mythical quality, and continue to be demanded for decades after their production. While other items become worthless pieces of junk.
Being able to tell the difference requires a great deal of skill and expertise.
One general issue with collectibles is that the industry is much more ‘self aware’ now than it was 50 years ago. When Star Wars miniatures were being manufactured decades ago, few individuals appreciated that toys such as these were even capable of holding or increasing in value.
As a result, very few examples were preserved and maintained in pristine condition. This widespread neglect then would become one of the driving factors behind their scarcity.
Having observed decades of collectable manias and having gained an understanding, the market for collectables is much larger. This leads to ‘over supply’ of items which are manufactured in higher volumes with collectors in mind. This undermines the investment case.
Different types of collectables are prone to move in and out of ‘fashion’, which can lead to disappointing returns for investors who bought items at what turned out to be a peak.
Liquidity – collectables
Collectibles are relatively liquid – they can be sold at auction within a few weeks. However, whether an investor will achieve a ‘good price’ for the item will be dependent upon the calibre of the bidders and whether a bidding war occurs or not.
It can be very difficult to reliably estimate the value of a collectable. The $558k bottle of wine I mentioned above, was actually listed for auction with a reserve price of only $32,000.
Structured products as an asset class
If you haven’t heard of structured products before, I wouldn’t be surprised.
Structured products are quite unusual, in that they have some high risk characteristics, are complicated in how they work, and yet they are marketed towards complete stock market novices.
Structured products are a blended investment product which usually combines a bond with derivatives, to provide an ‘equity-like’ return.
The distinguishing feature of structured products is that they usually include a level of price protection against small or moderate downward movements in the stock market.
Reward – structured products
Structure products can offer reasonable returns, such as 8% per annum for five years. These returns are conditional upon a named stock market index remaining at or above its starting value at the beginning of the investment term.
So long as the index closes at above its starting value, the investor will receive an advertised rate of return. However if the index closes lower, they may receive no return. Under the terms and conditions of the product (which vary from product to product) an investor will usually only lose capital if the index has fallen by a very significant amount.
Risk – structured products
A structured product will only pay out its advertised return if the counterparty to the derivative contracts is able to make good on its obligations. Therefore a structured product investor is exposed to the credit risk of that institution.
The returns of a structured product usually take a few minutes to fully understand, as they may carry a simple headline rate of return, but the number of different outcomes with different financial implications can number greater than 5.
Because a structured product return hinges so completely upon the value of an index at a fixed point in time, the investor becomes quite vulnerable to a sudden drop in the index as they approach the maturity date. A couple of % change in the index could make the difference between an investor receiving a 40% return or no return at all.
This is paradoxically how an asset class which first appears to be ‘low risk’ can actually present some pretty extreme volatility and stress for an investor.
Structured products are invested in for a fixed term. There is usually no provision for an investor to be able to exit the investment early, as their funds are used to buy long term assets which could result in a loss to the provider if they are sold early.
Read more: The magic behind structured products
Overall – asset classes overview
How you build your investment portfolio is up to you. Asset classes are only the broad ingredients that you may select from.
Sometimes an effective investment portfolio contains nothing more than equities and bonds. Others may include 5 or more different asset classes. More isn’t always better.
I hope that this overview of the different asset classes has helped you understand the breadth of investment options available to retail investors.