Another one of the questions I’m often asked about investing is, “What can I invest in? Like, what’s it even possible for me to buy?”
It’s surprising to find that many people (or maybe just the people I know), don’t know what they’re able to invest in.
A good place to start when answering this question is to go back to the basics.
Every portfolio that’s ever been created has been constructed by blending together different types of investments to match the investor’s tolerance for risk. Investors with a high tolerance for risk will buy riskier investments, and those with lower risk tolerances will buy less risky investments. Different types of investments are often grouped together into those which share common characteristics – know as ‘asset classes’. An asset class is a group of investments which share similar characteristics and are likely to behave in similar ways. So a portfolio of 30 different stocks would be invested in one asset class – equities. Some asset classes, like equities, are high risk with the potential for higher return, and some are lower risk usually with lower return.
At the end of the day, all investors will be investing in one or more asset classes. So a good way to think about what it’s possible to invest in, is to begin by going through what the different asset classes are, their characteristics, and how investors can access them.
Equities are the asset class that most people are familiar with. Also known as stocks or shares, equities are the major building block of most portfolios, and represent a share of a company’s profits. By owning the shares of a company, you’re entitled to a percentage of the profits the company makes, which are paid to you in the form of periodic dividend payments.
But dividend payments are only half of the equation – investors can also generate returns through an increasing stock price. As a company’s stock price is supposed to be based on the cash it will generate in the future, if the market thinks a company will generate more in earnings in the future (and so will pay higher dividends in the future), then the stock price will increase. An increasing stock price can also be used to generate income through selling some or all of your shares.
Equities are considered one of the riskiest asset classes, because:
1) If the company you invested in goes bankrupt, then you are unlikely to recoup your initial investment, and
2) The future cashflows of equities are extremely difficult to forecast, so the price of an equity (which is a function of its future casfhlows), can fluctuate greatly in the short-medium term as information about the company is released to the market.
Because they’re one of the riskiest asset classes, they also come with a potentially higher return over the long term. Using equities as an example, the relationship between risk and return is explored in this post on risk.
Equities can be held directly – if you’re a DIY investor, then you can buy a company’s shares through a platform. Or they can also be held indirectly through funds – either active mutual funds, index funds, or ETFs, again bought and sold through platforms.
Shares in a company are initially issued by the company itself, but most of the trading in equities occurs on an exchange between investors (known as a “secondary market”). When buying shares through a platform, as most investors do, you’ll be buying and selling to other investors and not to the company.
The process of how to actually invest your cash will be covered in a later post, but both equity funds and direct stocks are easily accessible for almost all investors, and the cost of investing in them is coming down all the time.
Bonds are the other main building block of portfolios, and are effectively a loan from an investor to a company. Bonds are a form of debt – they represent the company that needs money borrowing it from people who want to lend money to generate a return. Bonds can take many different forms – they usually pay a regular interest payment in the form of a ‘coupon’ (but not always), and they can have different interest rates – either fixed or variable – and different maturities. Sometimes they can be bought back by the company or sold back to the company before maturity.
When a company decides to issue a bond, the bond is priced at ‘par value’, usually a multiple of £100. The interest rate is set at, say, 3% for 5 years, which means that you buy the bond from the company for £100 (your ‘principal’), then every year you receive interest of £3, and after 5 years you receive your initial £100 investment back.
The risk of a bond depends on 2 things – how likely it is that the company you lent your money to goes bust (known as ‘credit risk’ or ‘default risk’), and how long the bond has until maturity (known as ‘duration risk’).
If a company goes bankrupt before the bond matures, you may not receive your initial investment back – this is credit risk. The likelihood of you receiving your principal back is dependent on the company’s financial health, which is measured by a ‘credit rating’. Well-known credit rating agencies include Moody’s, Fitch, and S&P, who assign each company with a rating based on the company’s likelihood of default (the company going bust). However, in the event of a default, you might still get some of your money back. The likelihood of this depends on how high up the pecking order you are when liquidators determine who gets their money back. ‘Secured’ bondholders (those whose bonds are secured against assets of the company) are more likely to receive their principal back than ‘unsecured’ bondholders.
To compensate for the additional risk, bonds issued by riskier companies with less protection in the event of bankruptcy usually come with a higher coupon, and so generate a higher return for the investor if the company doesn’t default.
Duration risk is the idea that bonds with a longer maturity are riskier. They’re riskier because they are more likely to suffer from both interest rate risk and inflation risk. Interest rate risk is the risk that interest rates rise after you’ve bought the bond, and so you could be receiving a better interest rate in a less-risky investment (e.g. a savings account), but are tied into the bond. Because of this, bonds become less attractive when interest rates rise, and so when rates rise, bond prices fall. The longer the maturity of the bond, the more likely that interest rates will rise as you’re holding the bond.
Inflation risk is the risk that inflation increases after you’ve bought the bond, so your coupon payments and principal repayment at maturity are worth less because inflation has eroded their value. The longer the maturity of the bond, the more likely that inflation will erode the bond’s income.
Bonds can also be issued by governments, called ‘sovereign debt’ – examples of which being UK gilts, and US treasuries. Government bonds from developed economies are thought to be the safest form of debt as the government is extremely likely to pay back the initial principal.
Because bonds can be issued by any company, and their construction can be very flexible, the risk of a bond depends on who issued it, and the specifics of the bond itself. Usually bonds are thought of as safer than equities, as the most popular bonds are those issued by governments, and companies with high credit ratings. High quality bonds are usually bought to offset the risk of equities.
Bonds can be bought directly from the issuer, but this is usually only possible for institutions. Most investors own bonds indirectly through active bond funds, bond index funds, or bond ETFs. Direct bonds are bought and sold between investors, but not via regular exchanges (they’re traded ‘over-the-counter’, i.e. directly with people in their network). Bond funds are bought either from the fund management company in the case of regular bond mutual/index funds, or over an exchange in the case of bond ETFs.
For most DIY investors, the easiest way to gain exposure to bonds is via bond funds bought on a platform.
Real estate, like bonds and equities, can be held either directly or indirectly.
Holding directly involves physically buying buy-to-let properties and generating returns through rental income and house price appreciation.
Holding indirectly involves buying a property fund which itself holds many buy-to-let properties – sometimes purely residential properties, but often they hold a diverse portfolio of commercial real estate properties like warehouses and office buildings.
On the risk spectrum, real estate is often thought to be between bonds and equities. It provides a relatively stable rental income (like bonds), but property prices can fluctuate dramatically (like equities).
Direct real-estate investment is a common way for people unfamiliar with the stock market to invest. Property is easy to understand and people like owning something they can touch. But most people aren’t able to afford to buy a truly diversified portfolio of buy-to-let properties – they’ll tend to only buy one or two properties. Often, the properties will all be residential, and often they’ll all be in a similar area. This means they’re all subject to the same local property market risks as each other, and when one falls in value, they all do. Transaction costs are also much higher for direct investment in property, which increases the rate of return required to break even.
However, direct property investing does have the advantage of leverage (borrowing to invest), which can enhance returns if property prices increase over the life of the investment.
For most investors, investing through real estate funds is a cheaper, and more liquid, way of investing in real estate. Commercial property funds not only provide diversification between properties within the fund, but they also provide diversification away from the residential property exposure which makes up a large portion of most investors’ portfolios – their house.
A commodity is something which is used as a basic material for building/making other products, and which is generally of a similar quality no matter who you buy it from.
Examples include oil, coffee, gold (and other precious metals), and wheat (and other grains).
Commodities don’t tend to generate income, and require physical storage if you buy the commodities themselves. Because most people want to avoid having to store 200 tonnes of wheat, most people achieve exposure to commodities through futures contracts, which are tradeable contracts based on the price of the commodity, and avoid the need to actually buy the commodity itself.
Most DIY investors gain exposure through commodity ETFs which usually hold a basket of futures contracts, although there are an increasing number of ETFs backed by the physical commodity (particularly gold). Either way, it’s possible for investors to gain commodities exposure through funds offered by most platforms.
Alternatives are just that – alternative. They’re a bit different to stocks, bonds, real estate, and commodities, and tend to include investments which don’t fit into a traditional asset class bucket. Common alternatives include hedge funds, private equity/venture capital funds, and derivatives but can include anything from stamp collecting to investing in art, to investing in cryptocurrencies. Sometimes real estate and commodities are also included in the ‘alternatives’ bucket.
Alternatives are usually introduced to be uncorrelated to other investments in the portfolio, often with an ‘absolute return’ objective (i.e. generating small but positive returns in most market environments).
They tend to be less liquid, less regulated, more complex, have higher minimum investments, and be more expensive than regular funds. They are also less transparent with underlying holdings and less clear with performance reporting.
Most hedge funds and PE/VC funds are impossible for regular investors to access, and are mainly held by large institutional investors, but some so-called ‘liquid-alt’ funds do exist. These are hedge funds which offer more liquidity and lower minimums, and are offered to regular investors.
Whilst it is possible to invest in alternatives funds, given their lighter regulation, lack of transparency, and general complexity, investors need to conduct extensive due diligence before investing in alternatives.
A final brief mention should be given to cash. Although cash is technically an asset class, cash is not an investment. Whilst some people view cash as “risk-free”, in the sense that you can’t lose your money through market movements, over the long run you’re guaranteed to lose money as your cash is slowly eroded by inflation, which I’ve written about in this post.
Hopefully this has proved to be a useful introduction to what it’s possible for you to invest in.
How you blend the different asset classes together to form a portfolio is an extremely personal decision, and is dependent on a huge number of factors which I won’t go into here (but will touch on in future posts).
The next post in this ‘Basics’ series looks at the logistics of investing, and how DIY investors are able to actually start putting their money to work.