What are asset classes and why should I care?
One of the most important decisions you can make is how much money you spread amongst the four major asset classes: cash, fixed interest, property and shares.
Why? Because asset classes are the foundations of your investment plan. Think of them like the foundations of your home. If they aren’t put together in the right way, your floor might be uneven, walls a bit wonky and possibly fall down like a house of cards.
The same can be said of your investment plan – if you don’t lay your asset class foundations correctly, you might not have the money you need to achieve your savings goal.
Sounds easy right? If it was that easy we’d all be millionaires.
Defensive or Growth?
Because some asset classes have a few similarities, we can divide them into teams: Defensive and Growth.
When you want a Defensive team, your foundations are laid with cash and fixed interest assets. These assets usually provide income and very little growth. They are useful when you:
- Have a short-term time frame, such as buying a car in a year
- Aren’t comfortable with taking on extra risk to chase higher returns
- Want something secure which provides consistent returns
Your Growth team is made up of property and shares (also called ‘equities’). Use them when you:
- Have a long-term time frame of seven years or more, such as saving for retirement in 20 years
- Are comfortable with taking on extra risk to chase higher returns
- Want something which provides higher, long term returns
You don’t have to stick with one team or asset class. You can use all asset classes at once for example. How much you have of each varies from one person to the next depending on things like your goals, how long you are investing for and your tolerance of risk.
Getting the mix of assets right is quite a challenge however. This is where the expertise of specialists like share brokers, property valuers and investment managers come in handy if you don’t feel up to the task and why you’d be happy to pay them.
Regardless of who’s calling the shots, it's important to understand how your money’s being invested:
|Asset class||Investment timeframe||Perceived risk||Type of return||Examples|
|Cash||Short term (usually up to 3 years)||Low||Income. No growth||Cash management trusts, bank deposits, short-term government bonds|
|Fixed interest (inc. bonds)||Short to medium term (usually 2-5 years)||Low to Medium||Income & some growth||Term deposits, bonds, debentures, secured & unsecured notes|
|Property||Long term (usually 7 years or more)||High||Income & growth||Residential, retail, commercial hotels & listed property trusts|
|Shares||Long term (usually 7 years or more)||High||Growth & some income||Shares listed on the Australian & international stock exchanges and share trusts|
The four P's: Prior Performance doesn't Predict future Performance
Before you decide where you’ll put your hard-earned money, you might want to have a look at how each asset class has performed over the last 20 years.
In the past, growth assets (shares and property) have provided higher long term returns compared to defensive assets (cash and fixed interest). However, as you can see from the graph below, if you want higher returns you need to be comfortable with watching the value of your growth assets go up and down a lot. This is known as volatility.
Property has been the most volatile, from as high as 43% and as low as -58% (yes – that’s negative fifty eight percent). Cash on the other hand, has plodded along nicely providing income returns of between 10% and 3% - no negatives there.
So unless you can travel back from the future, there’s no way to know how each asset is going to perform in the future. Since time travel isn’t possible yet, the best we can do is diversify our investments within and across asset classes, giving you an opportunity to hedge your bets.
If you’d like to know more about diversification, read our article Hedging your bets with diversification.
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