What are the major asset classes?
One thing that can be helpful to understand asset classes is to remember the food pyramid taught in grade school health class. The bottom of the pyramid has the least risk and the least reward, however, it is essential to daily life. At the top of the pyramid are the riskiest assets. The most potential upside but also the most potential downside; think of these as the sugars and sweets of our diet. The sugar high feels really good but they also run health risks. At the base of the asset class pyramid is cash. At the top of the pyramid are commodities and other speculative assets we won’t cover in this blog, but you can reference our past blog post on speculating vs investing. We are talking about risk broadly in terms of how much these asset classes have historically fluctuated around their average returns, and not “risk tolerance”, which usually refers to the willingness or capacity that an individual investor has to take risk.
Cash is considered to be the safest asset from a stability of principal standpoint but has its own inherent risk that will be discussed shortly. Cash in its most generic form is physical money and checking accounts, but also includes equivalents such as savings account, high-yield savings, money markets (bank and mutual funds), certificates of deposits (CDs), treasury bills, and other short term investments that are highly liquid (the ease at which an asset can quickly be converted to cash without affecting its price).
The benefits of cash include the aforementioned stability of principal and liquidity. Cash does not have large fluctuations (referred to as volatility) that other asset classes have, and can be readily available when needed which is important for meeting short-term obligations such as living expenses. It is vital to know exactly how many dollars are going to be in your checking account to meet your mortgage payment tomorrow.
The benefit of knowing exactly how much will be in your account tomorrow comes with tradeoffs; the main risk associated with cash is purchasing power risk, more commonly known as inflation risk. Prices of goods have historically increased over time at a varying rate known as inflation. Inflation peaked at almost 10% last year. This means a dollar one year ago is only worth about 90 cents today in relative terms. Over a 20, 30 or 40 year period the increase in the price of goods erodes the value of a dollar. A gallon of gas in the 1990’s was less than $1.00 and today is north of $3.50 most places. While cash is essential and has a place in everyone’s asset allocation, it is not meant for long term growth.
Fixed income (bonds) in the most generic sense of risk – preservation of principal – is more risky than cash but less risky than stocks, real estate and commodities. Fixed income covers numerous debt securities including bonds, loans and other types of debt instruments. Fixed income is a contractual agreement between a creditor to loan money to a debtor in exchange for periodic interest payments (called coupons) and payment of principal (the original amount loaned) at an agreed upon date in the future called maturity.
Fixed income securities typically pay out a higher interest rate than cash (not always as is the case right now) to compensate the creditor for relinquishing control of the funds and loaning them to the debtor. Depending on the riskiness of the bonds (assed by their rating) they can pay significantly higher interest rates than cash. U.S. Government bonds are usually regarded as highly safe because of the explicit taxing authority of the government, and will often have lower coupon rates than corporate bonds that have a higher probability of default (when a company goes bankrupt). Another benefit of corporate bondholders is their status as a senior security. There is a contractual obligation of the company to make full payments (principal & interest) to bondholders before any income can be paid to stockholders in the form of earnings and dividends. Bond holders also have first claim on the company’s assets during liquidation in bankruptcy proceedings.
Fixed income does have inherent risk namely in the form of interest rate, inflation and default (also called credit) risks. Fixed income securities not held to maturity may lose principal value depending on changes in current interest rates. Investors who need to raise cash before bonds mature should be wary of interest rate risk. While bonds often pay more than cash, that does not mean they always outpace inflation. Government bond prices will often pay out coupons tied to expected long term inflation rates. Bond investors may keep pace with inflation but do not have the potential reward upside of other assets that can outpace inflation. Bonds also have default risk that is primarily associated with corporations in financial trouble and sovereign debt from riskier emerging market countries.
Fixed income securities unique characteristics make them ideal for income oriented investors who don’t need the cash short-term and would like to earn higher interest payments than cash, but with less risk than other asset classes.
Stocks (also often referred to as equities) are ownership interest in a company. Stockholders (shareholders) have a claim to the assets of a company after all liabilities have been paid back. Stockholders also have claim to annual income after all expenses have been paid, including interest payments to debtors and taxes. When you buy shares of a company you are buying a percentage of the equity of a company, making you a shareholder. Shares trade electronically on exchanges and markets that process millions of shares per second. This makes stock ownership nowadays much more liquid and marketable than in the past when physical stock certificates were issued to shareholders. Stocks have the potential for much higher returns than bonds but do come with additional risk and can be highly volatile (the pace and degree of price changes) at times, with speculative companies being extremely volatile.
Stock ownership allows investors to participate in the current success of a company and potential future growth. While creditors receive fixed payments for the life of bonds, well run companies can continue to grow earnings and pass those earnings onto shareholders via dividends and share buybacks. Stockholders also generate returns through capital appreciation when share prices increase. Through proper management companies can also increase margins and pass savings onto shareholders. Companies have pricing power, albeit different companies to different degrees. This means companies can raise prices and pass along increased costs to customers. Well run companies that can successfully execute these tasks are able to outpace inflation and earn shareholders long-term returns above inflation and fixed income securities. Long-term capital gains from selling stocks and qualified stock dividends are also taxed at a lower and preferential rate than fixed income.
Stock ownership also comes with the risk of being the first investors to get wiped out when companies fail. When a stock is purchased, unlike bonds, there is no contract requiring return of principal. Stockholders have the most junior claim to a company’s assets during bankruptcy; they come only after all creditors and preferred stockholders have been made whole. Stocks can also be highly volatile with daily price movements of double digit percentages based on one bad earnings report or macroeconomic factor. Because stocks can be so volatile investors should buy them with the expectation of holding them for a number of years; one day of price decrease could take years to recoup the original investment. Not all companies have pricing power to pass on inflation costs to consumers. And not all companies have a good management team to execute business objectives.
Stocks combination of income and capital appreciation and ability to outpace inflation make them optimal investments for all kinds of investors from income to growth oriented. However, not every investor has the risk-appetite to potentially lose money on their investment.
Some people lump real estate into the “Real Assets” category with commodities and precious metals. Real estate, unlike stocks and bonds, is physical property you can touch. Real estate can refer to residential such as personal residence or commercial properties like industrial, office, retail and housing. Real estate can provide income, capital appreciation, or both.
Real estate has historically been a hedge against inflation. Property owners are able to pass increased cost on to tenants via rent increases. Additionally, real estate in desirable locations has the potential to appreciate in value, sometimes substantially. Leverage (financing the acquisition with debt) allows investors to buy real estate with less cash than the full purchase price. The creditor has a claim to the property if the debtor cannot continue to make payments. This is called securitization and allows investors in real estate to buy property without the full cash outlay, and a better interest rate, by giving creditors a lien on the property.
Leverage, however, is a double edged sword. When properties decrease in value, the debtor (property owner) is the first to have their equity wiped out. Just as appreciation is magnified with debt, so is depreciation. If an investor puts 10% down and leverages 90% of their investment, a 10% decrease in the property value has completely wiped out their equity. Real estate has historically seen large price declines during various recessions just as other asset classes have sold off. Real estate is illiquid and can be a months long process to complete a transaction and have cash in hand from the sale. Other ancillary risk factors include significant upfront cost to acquire a property, transaction fees, and ongoing maintenance. On the flip side, real estate also has tax benefits like depreciation and deferring capital gains on sale not available to stockholders or bondholders.
Similar to stocks, real estate is an important part of growth and income oriented investor portfolios but does come with risks that should be considered by investors.
Commodities are also real assets. Commodities include precious metals like gold and silver; fossil fuels such as oil and natural gas; and grains and livestock. Commodities are also referred to as “raw materials” and “resources.” Often commodities are an input and resource to another product. Metals are used in catalytic converters. Grains are processed for flour. Fossil fuels used to generate electricity.
Commodities can provide diversification and potential protection against inflation. Oftentimes commodity prices rise during periods of high inflation as we have seen with gasoline prices and eggs, just to name a couple.
Commodities can be highly volatile with rapidly changing prices based on supply and demand. One extreme example of this was crude oil prices during Covid. With global economies shut down, crude oil prices actually went negative over fears of dried up demand. With cars not driving and planes not flying, there was no demand to keep up with the production output oil companies were supplying to the market.
Asset Classes vs Asset Allocation?
In next month’s blog, we will be discussing “Asset Allocation” and how each of these asset classes fits into each person’s portfolio differently depending on their particular qualitative and quantitative factors.