Stocks, options and bonds…oh my!
Frankly, the number of different financial products out there can be overwhelming. Add to that the maddening financial jargon used to describe these products and it becomes a perfect storm of frustration and helplessness. Totally unnecessary.
Remember this. There are 5 main types of financial products out there, also known as asset classes:
- Fixed Income
- Real Estate
- Equities (stocks, ETFs, options..etc)
Fixed Income Asset Class
Better known as bonds, this asset class is the next best thing to cash in terms of stability. Bonds promise to make payments on specific dates and those payments are guaranteed. The risk for bonds is much lower than for stocks. Because of that, the return on bonds is also lower than most other asset classes.
If you’re the type of investor who is risk averse, i.e., doesn’t like taking too much risk, and are quite pleased with a modest amount of return on your investments, the guaranteed payments feature of fixed income asset class investments makes it your best investment bet. When you know how much money you’ll receive periodically, you’ll be able to make better financial decisions and formulate good financial strategies for helping you achieve your investment goals.
Another advantage to investing in fixed income securities is that it can be used as collateral for borrowing money, especially if you invested in government securities. The security of payment of principal and interest income makes it an acceptable collateral for many lending institutions.
If you’re very particular about earning meaningful returns on your investments, the bad news with fixed income securities is that it would be futile to expect substantial returns. And if you’re comfortable taking on higher risks just to get the significant returns you really want, it’s better to invest in a different asset classes. Its most significant advantage, which is its significantly lower risk, is responsible for its biggest disadvantage as well.
Another disadvantage to investing in fixed income securities is liquidity. Many fixed income assets tend to tie up investors’ money for long periods of time so if you foresee that you’ll be needing your investment money anytime soon, consider other classes of investments.
Why I would invest in Fixed income: If you are looking for stable, regular income without the instability of the stock market.
Commodities Asset Class
Investing in commodities means investing in tangible raw materials like gold and copper or primary agricultural products like coffee and corn.
If you’re an investor with a voracious appetite for taking risks just to earn huge returns, then the commodity asset class may just be the one for you. For one, the prices of commodities in organized trading exchanges such as the Chicago Mercantile Exchange can swing wildly in such a short period of time. These wild swings, though highly risky, provides opportunities to hit the investment jackpot.
Another advantage of commodities investments is that compared to just about any other asset class, commodities are friends with inflation. Inflation is the rate of increase in the prices of basic goods and services, including commodities, and as such, inflation pushes the prices of commodities higher. That provides commodities investments a nice push, even during high inflation periods. Other investment classes tend to perform poorly during high inflation regimes.
If you’re a risk averse investor, you should avoid investing in commodities like the plague. It’s because it’s potential to give you huge returns also gives you the potential to lose a lot of money quickly. Remember, the higher the expected return, the higher the risk. Those wild price swings I talked about earlier can – in the wink of an eye – turn your handsome profits to ugly losses. Compared to other asset classes, this one’s not for the faint of heart.
Another disadvantage to investing or trading in commodities, especially in organized exchanges, is that it can be rather expensive and complex. Again, this type of investment class is not for the simpleton or ordinary investor and is best left to the pros.
Why I would invest in Commodities: If you believe that buying gold (or any other commodity) is safer than investing in companies. You know the returns probably won’t be as high, but are happy with the security.
Real Estate Asset Class
One of the largest asset classes, real estate is the most easily understood by investors. Essentially when we buy, rent or sell a property, we are investing in it. The risk associated with real estate is greater than with bonds as we are not certain what amount we can sell the property for in future. Nevertheless, real estate has much lower than that of stocks or commodities, because housing prices generally don’t fall too much if they fall. (The housing bubble of 2008 being the exception.)
Investing in real estate asset class gives you the benefit of dual returns if you decide to rent out the property you bought: fixed income and capital appreciation. The rental payments to you by tenants or lessees can be considered as fixed income and significantly higher compared to when you invest in fixed income securities. Plus, while you rent out your property, it’s market value increases over time, which you can realize if you sell it later on. If you don’t decide to lease out your property, you can still earn a significant return on your investment later on if you sell it.
The biggest disadvantage of investing in real estate is cost. You need a lot of money to purchase properties for investment. While it’s true that you can borrow money to finance your real estate investment, it can be very risky especially if you’re not able to rent it out immediately or at an amount that will allow you to consistently make payments on the loan.
Compared to all the other investments in our list of asset classes, real estate investments are the least liquid, i.e., the hardest to convert back into cash. While fixed income investments may tie up your money for a while, it’s relatively easier to sell it in the secondary market compared to properties.
Why I would invest in Real Estate: If you have a lot of money to invest (real estate is really expensive!) and are looking for a big return, but don’t mind waiting a long time to get your money back.
Cash Asset Class
This does not just mean the money in your wallet or the bank (phew!). This includes bank deposits, Certificate of deposits, GICs, Money Market Funds, and pretty much anything else that can be converted into cash at a moment’s notice without losing value.
This is the safest asset class.
The single biggest advantage – and possibly the only one – of allocating resources in cash asset class investments is liquidity. Whenever you need cash, you’re practically sure of getting it. It allows you to ensure you have enough cash on hand for your personal needs without keeping such cash idle, i.e. not earning income. For example, you receive your salary today but since you charge most of your expenses to your credit card, the bills of which are payable at the end of each month, you can invest that portion of the money you received allocated for credit card payment in cash assets. That way, you have enough money for paying your bills and still earn some income on the side. Your money can be making money without you having to lift a finger!
There’s always a trade off between risk and return – that’s an inviolable principle in finance. Compared to all the other major asset classes, cash assets are obviously the most liquid and have the least risk for losses. Because of the low risk and high liquidity cash asset class’s single biggest disadvantage is that the returns are very low. In fact, it’s very low risk makes it the least profitable of all investment asset classes.
When you factor in inflation, you may even come to the conclusion that this can’t be considered an investment at all. With its very low returns, which can sometimes be lower than the inflation rate, your money’s purchasing power actually goes down. Then again, the primary purpose for allocating resources in cash assets is liquidity over returns.
Why I would invest in Cash: You are absolutely and completely turned off by the idea of risking any of your money in investment or you need to stay extremely liquid.
Equity Asset Class
This Asset Class includes anything that represents ownership. The ownership could be in:
- A company, known as a stock.
- A collection of assets, known as an Exchange Traded Funds (ETF’s).
Equities are probably one of the most used asset classes, especially since the introduction of the ETF (side-note: Anytime acronyms are used to explain financial terms there is bound to be trouble – ETF’s have a dedicated learning section in the course Putting your Money in the Market, Chapter 3: Investor’s Toolbox.) At their core, ETF’s allow you to invest in virtually anything. For example, you can invest in Gold, Silver, Oil, interest rates – you can even invest in price fluctuations!
This is a risky asset class because you are basically betting that a particular equity will increase in value – and although this is greatly desired – it is not always the case. For example, in order for stock prices to increase, not only must the company produce an awesome product, but the economy as a whole needs to be doing well to ensure that there is demand for the product. Only then will the company’s earnings increase, resulting in a higher stock price (more money for you!).
That said, it is definitely not the riskiest asset class, as a lot of stocks and ETFs make regular payments called dividends to the investor. Dividends are quarterly payments some companies make to their shareholders. There are also different levels of risk associated with different stocks. Blue chip stocks are considered less risky, while penny stocks are considered extremely risky.
The biggest advantage to allocating resources in equity asset class investments is a good balance of liquidity and potentially high returns. Next to cash asset class investments, which are already cash or near cash anyway, investments in equities that are traded in the biggest organized stock exchanges (such as the New York Stock Exchange (NYSE) and NASDAQ) are very, very liquid or easy to sell and convert to cash. Given its liquidity, equity can provide superior returns that can only be exceeded by the riskiest asset class, commodities. It’s not unheard of for people to double their money within one year when investing in stocks.
Another advantage with this asset class is that for equities’ high potential returns, it’s not as complicated or costly to invest in compared to commodities or real estate asset classes. As such, it’s a good investment even for relatively novice investors.
As with other asset classes that offer potentially high returns, investing in equities can be considered relatively higher in risk compared to cash assets, fixed income and real estate investments. While it’s possible to double your money within one year, it’s also possible to see the value of your investments drop within the same time frame, especially during times of economic crisis such as in 2008’s sub-prime mortgage crisis.
That being said, such losses will only be “paper loses” or market losses that you will only realize when you actually sell at lower prices. For as long as you hold on to your investments, there’s still a possibility for prices to climb back up and even exceed your acquisition price. But if you sell, there’s no more chance of recovering your losses. It’s important to remember that the market is cyclical, so it’s important to not jump the gun and hold off selling your assets because the market generally bounces back.
Why I would invest in Stocks: If you believe in the market, and more importantly, making money on the market. Stocks will give you returns and a sense of ownership that very few of the other asset classes can come close to matching.
There you have it!!!!
There’s something for everyone in the finance world. Whether you’re risk adverse or need the thrill of living on the edge, there is an asset class with your name on it.