The Advantages and Disadvantages of Different Asset Classes

investing for beginners can be tricky. With so many asset classes available, most people don’t know where to start or what to invest in. Different asset classes are beneficial in some situations but risky in others. As legendary hedge fund manager Ray Dalio says “Bonds will perform best during times of disinflationary recession, stocks will perform best during periods of growth, and cash will be the most attractive when money is tight.

What Dalio is saying is that different asset classes have environmental biases. They do well in certain environments and poorly in others. Also, different asset classes have historically produced different rates of returns for investors.

In this article, we give an overview of the different asset classes, give their benefits and drawbacks and state when they are best.

Stocks and Shares (Equities)

A share (often referred to as equity) is your claim to a part ownership of a company listed on a stock exchange. If a company is worth £200 million and has issued 200 million shares then each share is valued at £1. The overall value of the company fluctuates based on a variety of factors including demand and supply for the goods or service the company is offering, it’s future prospects, merger and acquisition activity, competitor activity and the economic environment to name a few, all of which can impact the share price.

Advantages of stocks are:

• Great long-term returns – stocks have historically delivered better returns over the long-term than other asset classes such as bonds, cash and even housing (link to article). Despite the recent dot com bubble and the financial crises which had devastating effects on the stock market, the case for investing in equities over the long-term still remains strong as these short term market downturns have less impact when investing for a period of 10 years or more.
• Global exposure – your investment in equities is not restricted to companies in the US or the UK, By investing in multinational companies, you gain exposure on a global basis and thus you ca reap rewards as the global economy grows.
• Inflation proofing – With most central banks carrying out quantitative easing, inflation is set to increase over the next few years. In many parts of the world today, you actually see inflation running higher than interest rates, hence the real value of cash savings is being constantly eroded over time. Given their inherent potential for capital appreciation and the ability to deliver a growing income over the long-term, equities look attractive relative to other assets focused on income.
• Income – By investing in steady dividend paying stocks, you are able to get a steady stream of dividends which grows over time. (note that companies are not always obliged to pay dividends).

Disadvantages of stocks are:

• Drop in share price –a number of factors that can impact the price of shares, some of which are not always within the control of the company and this may have implications for the value of the share price. In some circumstances this may mean that the share price falls below the value you originally paid for it. As we have seen in recent times, economic downturns can significantly impact share prices. By their very nature stock markets fall and rise and if you invest for the long-term your investment has the opportunity to recover from any short term fall. Typically investing in the stock market should be taken as a 10 year view so if you need access to your money in the short term, say less than 5 years, then investing in the stock market is probably not for you.

Who should invest in the stock market: People who have a long time horizon i.e. 10 years or more.

When is the best time to hold stocks: During period of inflation, periods of increasing economic activity and periods of low interest rates.

 

Bonds

A bond or fixed income asset is effectively a type loan. A government or company can borrow money by issuing a bond. In return for lending the money the lender receives interest payments from the borrower and also receives original loan amount when the bond matures.

Advantages of bonds are:

• Lower risk than equities – a company is contractually obliged to pay the interest on a bond. Therefore if a company runs into financial trouble bond holders rank ahead of equity holders for repayment.
• Regular income – bonds pay interest at fixed regular intervals. This continuos tram of income make them appealing to those approaching or in retirement or may be seeking a regular income payment.
• Diversification – Historically, bonds and stocks do not respond to market events in the same way. So in a bear market where stocks may be declining in value, bonds may be experiencing strong returns. This is not always the case though, but holding bonds and equities in a portfolio provides diversification and can help to reduce investment risk when compared to investing in a single asset class.

Disadvantages of bonds are:

• Low returns – Bonds typically offer lower returns than equities over the long term. This is because bonds are less risky for investors to hold.
• Bond issuer defaults – if the company which issued the bonds you hold goes bankrupt, you risk losing all the money you borrowed that company.
• Changes in interest rates – As interest rates increase, the price of bonds fall.

Who should invest in the stock market: People who are nearing retirement. People who want a dafe return.

When is the best time to hold stocks: During period of deflation, periods of economic uncertainty or when interest rates are high.

 

Property

Property Investing has become a favourite of many British investors today. Investors normally invest in residential property via buy-to-let or the recent phenomenon of property crowd funding (see property moose and the house crowd). If investors want commercial property in their portfolio, they will normally buy into a REIT – a real estate investment trust (listed on the stock exchange).

Advantages of investing in property are:

• High Return potential – property offers the potential for attractive long-term returns as a result of capital appreciation and rental income.
• Regular Income stream – property can provide an attractive and regular income stream for investors as a result of rents from the property. This is often one of the primary reasons for investing in property.

Disadvantages of investing in property:

• Hard to sell (illiquid) – Where as you can sell stocks or bonds within seconds, it could take months to sell a house.Selling property quickly is not easy and in order to do so, the property may have to be sold at a price that is lower than the price you initially paid for it.
• Property crash – we all know what happened in 2007/2008. If another crash comes along, you could lose more than 50% of the value of your property.
• Interest Rate rises – When interest rates rise, your mortgage becomes more expensive. This particularly affect buy-to-let and REITs. Also, when interest rates begin to rise, house prices should begin to fall as more people will either not be able to afford a mortgage or will default on their mortgage.

Who should invest in the stock market: People looking for great returns outside the stock market.

When is the best time to hold stocks: During period of inflation or low interest rates.

 

Private Companies

You can invest in companies that are not listed on the stock exchange (also called Private Equity). You can invest in private companies in the star-up phase using websites like Crowdcube and Seedrs.

Advantages of investing in private companies:

• Potential for high returns – by identifying companies with the potential for rapid growth and investing in them in their stray-up or early stages, there is the potential for higher returns than traditional companies listed on the stock exchange.

Disadvantages of investing in private companies

• High Risk – Due to the fact that as a small investor you might only be able to invest in young companies, there is a high chance that these new companies will not survive and therefore it is a much riskier investment than investing in larger established companies.

Who should invest in private companies: Entrepreneurs who know what it takes to run a business.

When is the best time to hold stocks: When the stock market is overvalued.

Cash

Cash is the most familiar form of investment for most people. We use it on an everyday basis and have a bank account which may pay a level of interest on the savings we hold within it.

Advantages of cash as an investment

• Safety –The main reason many people hold cash is safety. Cash is the safest form of investment and the government will protect up to £85,000 held in a bank account should that particular bank run into difficulties or default (but this is about to reduce to £75,000 next year).
• Liquid – Cash accounts make sense for savings that you will need access quickly or as an emergency fund to cover unexpected expenses.
• Dry powder – You will find that this is the best reason to hold on to cash. By having your money in cash as opposed to it being locked up in investments, you can move quickly to acquire an investment you like. If there is a market crash and stocks, bonds or property are going for cheap, you can mobilise this cash quickly and buy into investments at a cheap or discounted price.

Disadvantages of cash as an investment

• Low returns – Holding money in cash offers close to 0% returns in todays low interest rate climate. But there are new fin tech startups like Fruitful( LINK), that allow you to have access to your money quickly whilst still paying you a rate of 6%- 7% on your money.
• Inflation –The biggest risk to holding cash is inflation. Over time the level of inflation erodes the real value of your cash savings. If inflation is running at around 3% your savings are not earning enough interest to keep pace with the cost of living and therefore you are effectively losing money.

Who should invest in the stock market: People looking to preserve their capital

When is the best time to hold stocks: During period of deflation.