The Asset Classes Explained

In its simplest form, an investment portfolio represents the assets which an individual owns and is generally divided into four key classes: cash, shares, bonds and property. A key objective for all investors when building their portfolio is to ensure an appropriate balance among each asset class to suit their particular profile and circumstances. Fundamental to this end is a basic understanding of the key characteristics of each, as outlined below.

Cash deposits

Since it makes no sense to lock away money that you will need in the near future, cash investments such as deposit bank accounts provide investors with a source of liquidity for short-term commitments and emergencies. Cash deposits provide a safe alternative in so far as the principal is guaranteed while the investor also benefits from a stream of income in the form of interest payments. However, these payments may vary with prevailing interest rates and may not appreciate sufficiently to offset the detrimental impact of inflation which erodes the real purchasing power of your money. For this reason, most successful investment portfolios do not allocate a substantial portion of funds to cash deposits.

Shares

Shares allow an individual to become a part owner of a company without having to participate in the management or operation of that business. Investors can earn a return from holding shares in two ways. Firstly, as the company generates profits, these may be divided amongst the shareholders by way of a dividend. Secondly, if the business continues to perform well, this may lead to an increase in the value of the share. However, part ownership of a company essentially means accepting the bad times as well as the good. In periods of poor performance, or when the company disappoints investors by producing lower than expected profits, the stock may decrease in value. In severe circumstances, the company may also stop paying a dividend. Shares can be quite volatile over the short term and thus are characterised by a higher risk profile. However, over the long term, shares have historically proven to be the best performing asset class.

Bonds

Bonds are essentially loan arrangements between borrowers (issuers) and investors (bondholders). Issuers, which can be either governments or companies, agree to make payments of interest (coupon payments) to the bondholder for the duration of the bond and also to repay the original principal at the maturity. The terms are agreed at the time of issue and would generally include the rate at which interest is paid, the frequency of each payment and the maturity date. Given that an investor knows the bond's income stream in advance and how much will be received if it is held to maturity, this asset can provide a predictable level of return. However, the price of a bond can vary significantly over its maturity period, depending on prevailing interest rates. As a general rule, when prevailing interest rates rise, the value of a bond falls and vice versa.

Property

Property can hold numerous attractions for private investors. As well as providing a more visible investment, this asset offers the appeal of future income in the form of rental payments. Property also offers the potential of steady long term capital appreciation, without the price volatility typically associated with equities. In the past, many private client investors were restricted from investing directly in property (be it residential or commercial) due to the high level of capital required. However, this has changed as a result of rising wealth, increasing investor awareness and more attractive borrowing facilities. Most financial institutions permit property to be used as security for borrowings, which allows investors to finance transactions without 100% capital. Furthermore, in certain cases, interest on borrowings may be offset against rental income, thus reducing future tax liabilities. However, property is less liquid than other assets and disposal maybe a lengthy process. Furthermore, it typically incurs a higher level of transaction costs such as stamp duty, legal and surveyor fees.