An asset class is a category of investments that exhibit similar characteristics in the market place. The investments within a single asset class are expected to:
- have similar risks and returns
- be subject to the same laws and regulations
- perform in a similar manner in particular market conditions.
Each different asset class is expected to:
- reflect different risk and return characteristics
- perform differently in different market conditions.
Understanding what to expect from each asset class helps you make appropriate investment decisions based on your varying needs and timeframes. Financial theory suggests that by investing in more than one asset class investors can diversify their investments and reduce risk while maintaining an overall target return.
Types of asset classes
There are four main types of asset classes, each categorised into either defensive or growth. The table below highlights the characteristics of each asset class.
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|
Asset class |
Characteristics |
Risk |
Potential return |
|
Defensive assets
(focus on generating income) |
Cash includes bank deposits, term deposits, savings and cheque accounts and cash management trusts |
Suitable for investors who have a short term outlook, a low tolerance to risk, or if market volatility is high. Provides a stable and low risk income, usually equally in the form of regular interest payments. No recommended minimum timeframe. |
Low |
Low |
|
Fixed Interest includes government bonds, corporate bonds, mortgages and hybrid securities |
Can be more volatile than cash, but are still relatively stable. Generally operate in the same way as a loan. Income return is usually in the form of regular interest payments for an agreed period of time. Minimum suggested time frame: 1 – 3 years |
Low/ Moderate |
Moderate |
|
|
Growth assets
(focus on capital growth and income) |
Property
includes direct investments in residential, industrial and commercial property and can also include indirect investment in listed property vehicles such as REITS |
Has a higher risk than fixed interest but less risk than equities. Less liquid than other asset classes resulting in a higher recommended minimum timeframe. Entry and exit costs significantly higher. Minimum suggested timeframe: 7+ years |
Moderate/ High |
Moderate/ High |
|
Equities
includes Australian equities and International equities |
Returns usually include capital growth or loss and income through dividends which may be franked (ie the company has already paid tax on the earnings). The most volatile asset class but over long periods of time, on average, has achieved higher investment returns. Involves part ownership of a company, enabling investor to share in the profits and future growth. Currency valuations can affect performance of International equities. Minimum suggested timeframe: 5 – 7 years |
High |
High |
The Economic Clock
Historically, markets have tended to operate in cycles where periods of financial downturn have typically been followed by periods of growth. The Economic Clock illustrates this cycle. This clock (which is also called the Investment Clock) first appeared in 1937 in England.
The economic clock is pictorial summary of the economic cycle and demonstrates that as an economy moves through its cycle there generally is a time to buy certain types of investments and possibly times not to buy. Generally, the cycle starts with a peak in interest rates and after interest rates fall, the share market rises, followed by a rise in commodities, then inflation and finally property. Interest rates then rise to curb inflation and then the cycle goes into decline and so the cycle goes on.
Investors can use the economic clock as a tool to understand the economic (or boom and bust) cycle and determine where the economy is in the cycle at any given time. Obviously the clock is not foolproof but it can be used as a model for depicting the normal sequence of events for the share and property markets. Investors can take advantage of evidence from history to time their long term investments.
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The economic clock is not a signal to show you what to buy to become wealthy but it does show that the return a particular investment may generate will depend on what phase the economic cycle is in, or in other words, what time it is on the economic clock. |
Diversification
Diversification is the practise of “not sticking all your eggs in one basket”. Investing across a number of asset classes is generally accepted to be a valid risk management strategy. The definition of diversification is reducing risk by investing in a variety of assets within a portfolio. The rationale behind diversification is that a portfolio of different investments will, on average, yield higher returns and pose a lower risk than any individual investment within the portfolio.
Investment asset classes tend to follow trends and as we have seen in the last section on the economic clock, they tend to wane and peak at different times. So if you have all your assets in the one asset class you run the risk of suffering a big loss if that asset class is doing badly.
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You can diversify your investments across classes or you can diversify within an asset class by diversifying across sectors in the case of equities, or across localities in the case of property. If you have diversified assets, your total investment portfolio won’t be so impacted by a drop in value of one asset. However, it is important to remember not to spread your investments too thinly and don’t over-diversify. |