Asset Classes and Diversification
Advice on how to diversify your investment portfolio
What are Asset Classes?
Asset Classes are a way in which investments are grouped when they share similar characteristics. To properly diversify your investment you should ensure that your fund is exposed to a number of different asset classes.
Types of Asset Classes
Equities invest in company shares. They are an important component in a portfolio as they have traditionally produced good long-term growth. They produce returns either through paying dividends to shareholders or through capital growth in the share value. In the short term as the value of shares can rise and fall quite dramatically, higher risk portfolios will have a bigger weighting of equities.
Fixed Interest Bonds
Bonds are loans to Government or large corporates. They are generally used to reduce the overall risk in a portfolio. Investors in these bonds are entitled to a fixed income (coupon) up to a maturity date and also get their original capital back at maturity (subject to issuer’s ability to pay). Bond funds are likely to show lower growth potential than equity funds but are considerably less volatile.
Commercial Property funds pool different investors’ money together to make it easier to buy properties. The funds’ returns are generated from the rent the fund receives and any growth in the capital values of the properties held. Property is a very illiquid investment which means it can be difficult to release capital because it takes time to sell a property asset at an acceptable price.
Manufacturers and consumers across the globe require everyday commodities like wheat, corn and gold to conduct their business. The price of these commodities will rise and fall due to supply and demand. Investors look to make money by speculating on these rises and falls. Although they have a similar risk profile to equities, commodities behave differently and therefore mixing these can help reduce overall risk.
Cash funds are generally used to keep liquidity in a portfolio, or as a temporary position whilst timing a re-entry into the markets. Cash can also be held as an investment in its own right if it is paying an attractive rate of interest. When looking at investing in cash or deposits, it is important to consider the financial strength or credit rating, of the institution involved.
Alternative investments (known simply as “alternatives”) are investment strategies outside of traditional stocks, bonds and cash. Some common examples are private equity, venture capital, hedge funds, real estate, commodities and currencies. i.e. “alternatives” to fixed income and equity securities.
A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.
Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.
So why diversify? Because NO ONE can predict the future