Beginner’s Guide to Asset Classes
The investment landscape can be extremely dynamic and constantly changing. But those who take the time to understand the basics and the different asset classes have everything to gain in the long run.
The first step is to learn to distinguish between the different types of investments and the level that each occupies on the ârisk ladderâ.
Key points to remember
- Investing can be a daunting prospect for first-timers, with a huge variety of possible assets to add to a portfolio.
- The investment ârisk scaleâ identifies asset classes based on their relative degree of risk, with cash being the most stable investments and alternative investments often being the most volatile.
- Sticking with index funds or exchange traded funds that mirror the market is often the best course for a new investor.
How To Invest In Stocks: A Beginner’s Guide
Understanding the scale of investment risks
Here are the main asset classes, in ascending order of risk, on the investment risk scale.
A cash bank deposit is the simplest, most understandable, and most secure investment asset. Not only does it give investors precise knowledge of the interest they are going to earn, but it also ensures that they will get their principal back.
In contrast, interest earned on cash accumulated in a savings account rarely beats inflation. Certificates of deposit (CDs) are less liquid instruments, but generally offer higher interest rates than savings accounts. However, the money put into a CD is locked in for a period of time (months to years) and early withdrawal penalties are potentially involved.
A bond is a debt instrument representing a loan made by an investor to a borrower. A typical bond will involve a corporation or government agency, where the borrower will issue a fixed interest rate to the lender in exchange for the use of their principal. Bonds are commonplace in organizations that use them to fund operations, purchases, or other projects.
Bond rates are primarily determined by interest rates. For this reason, they are traded heavily during times of quantitative easing or when the Federal Reserve or other central banks raise interest rates.
A mutual fund is a type of investment in which several investors pool their money to buy securities. Mutual funds are not necessarily passive, as they are managed by portfolio managers who allocate and distribute the common investment in stocks, bonds and other securities. Individuals can invest in mutual funds for as little as $ 1,000 per share, allowing them to diversify into up to 100 different stocks contained in a given portfolio.
Sometimes, mutual funds are designed to mimic underlying indices such as the S&P 500 or the DOW Industrial Index. There are also many mutual funds that are actively managed, which means that they are maintained by portfolio managers who follow and carefully adjust their allocations within the fund. However, these funds generally have higher costs, such as an annual management fee and an opening fee, which can reduce an investor’s returns.
Mutual funds are valued at the end of the trading day and all buy and sell transactions are also executed after the market closes.
Exchange Traded Funds (ETFs)
Exchange Traded Funds (ETFs) have become very popular since their introduction in the mid-90s. ETFs are similar to mutual funds, but they trade throughout the day on the stock exchange. In this way, they reflect the behavior of buying and selling stocks. It also means that their value can change dramatically over the course of a trading day.
ETFs can track an underlying index such as the S&P 500 or any other âbasketâ of stocks with which the ETF issuer wishes to highlight a specific ETF. This can include anything from emerging markets, commodities, individual industries such as biotechnology or agriculture, and more. Due to the ease of trading and the wide coverage, ETFs are extremely popular with investors.
Stocks allow investors to participate in the success of the business through increases in stock prices and dividends. Shareholders have a right to the assets of the company in the event of liquidation (i.e. bankruptcy of the company) but do not own the assets.
Ordinary shareholders have the right to vote at general meetings. Holders of preferred shares do not have voting rights but enjoy a preference over ordinary shareholders in terms of payment of dividends.
There is a vast universe of alternative investments, comprising the following sectors:
- Real estate: Investors can acquire real estate by purchasing commercial or residential properties directly. Alternatively, they can buy stocks in real estate investment trusts (REITs). REITs act like mutual funds in which a group of investors pool their money to buy properties. They trade like stocks on the same exchange.
- Hedge funds and private equity fund: Hedge funds, which can invest in a range of assets designed to generate above-market returns, called “alpha”. However, performance is not guaranteed, and hedge funds can see incredible changes in returns, sometimes underperforming the market by a significant margin. Usually available only to accredited investors, these vehicles often require high initial investments of $ 1 million or more. They also tend to impose net worth requirements. Both types of investing can tie up an investor’s money for long periods of time.
- Merchandise: Commodities refer to tangible resources such as gold, silver, crude oil, as well as agricultural products.
How to invest wisely, conveniently and simply
Many seasoned investors diversify their portfolios using the asset classes listed above, the combination reflecting their tolerance for risk. Good advice for investors is to start with simple investments and then gradually expand their portfolios. Specifically, mutual funds or ETFs are a good first step, before moving on to individual stocks, real estate, and other alternative investments.
However, most people are too busy to worry about daily portfolio monitoring. Therefore, sticking to index funds that mirror the market is a viable solution. Steven Goldberg, Chief of Staff Tweddell Goldberg Investment Management and long-time mutual fund columnist at Kiplinger.com further claims that most people only need three index funds: one covering the US stock market, one focused on international equities, and the third following a large bond index.
The bottom line
Investing education is essential, as is avoiding investments that you don’t fully understand. Rely on good recommendations from experienced investors, while rejecting âemergency adviceâ from unreliable sources. When consulting with professionals, look for independent financial advisers who are only paid for their time, instead of those who take commissions. Most importantly, diversify your holdings across a wide range of assets.