As a child, you attended classes at school to make you smarter. The better you did in class, the more likely you were to graduate. (And if you’re reading this post, you must be pretty smart).
This is no different in finance. Think of finance as a school where different asset ‘classes’ help you become wealthier in different ways. The better you understand these asset classes, the more money you can make.
Asset classes can be grouped in two ways: traditional asset classes (i.e., equity and bonds) and alternative investments – everything else. This article will explain the difference between them so you can make better trades and reduce your financial risk.
Let’s dive in!
Part 1: Traditional asset classes – Equities and bonds
1. Equity (Shares)
Having shares means owning part of a company. When the company does well, the value of your stake rises – and vice versa. A company’s share price can fluctuate for many reasons, such as market conditions, the company’s reputation, and its competitors’ activities.
During the COVID-19 pandemic, for example, many people worked from home and used software like Zoom and Teams to communicate remotely. They used Amazon to order goods, TikTok and Netflix for entertainment, and DoorDash and UberEats for food. Because of this, these companies’ stock value rose significantly. If you’re interested, here’s a comprehensive list of stocks that rose and fell during the pandemic.
Meanwhile, travel was banned so the oil sector didn’t perform too well. Hotels and AirBnBs went unused, so travel and hospitality stocks were hurt by the pandemic. If you owned shares in movie theater chains, restaurants, and airlines, your stock portfolio would have likely suffered a loss.
Is buying shares risky?
Equities are considered risky due to how unpredictable they can be. Also, knowing which shares to buy can be difficult for a new investor. This is where consulting a financial advisor becomes useful as they can value different companies and advise you on which ones to buy shares in.
How do shares gain value?
There are two ways to gain value from buying shares: through dividends and capital appreciation.
- Dividends are paid to you out of the profit the company makes.
- Capital appreciation is when your initial investment grows as the company does well. For example, your $100 investment can become worth $200 after the company introduces a new product that sells well.
Some stocks pay dividends and others don’t, but all equities aim for capital growth.
A company that needs to raise money can take out a bank loan or sell bonds to the public. That bond acts as a contract between you and the company. You agree to loan the company a certain amount of money that will be paid back to you after a certain period. The company becomes the ‘bond issuer’ and you become the ‘bondholder.’
Bonds are considered a safer bet than equities. This is because priority is given to the loan repayments of bondholders, whether the company does well or is being liquidated. With equities, there is no guarantee you’ll get your initial investment back. However, bondholders are only lenders; they don’t have any stake in the company. If the share price goes up, bondholders don’t benefit from that upside (unless you own something called a “convertible bond”).
Just like equities, bonds have two types of returns:
- Coupons (similar to dividends), and
- Capital appreciation
Coupons are interest payments made to you. You might receive them in installments throughout the lifetime of the bond before the bond issuer repays you the bond’s original face value.
Capital appreciation happens when you decide to sell the bond at a price higher than what you paid for it. In that case, the buyer now gets any future coupons.
Not all bonds pay coupons. In some cases, bondholders gain by buying bonds cheaply from an issuer and getting a higher amount from the issuer when the bond matures. These types of bonds are called ‘discount bonds,’ which we’ll cover in a future article.
Part 2: Alternative investments
There are alternatives to traditional equities and bonds. These include investments like hedge funds, venture capital, commodities, and antique collections (such as art, silverware, and yes, even wine). Real estate is also considered an alternative investment. The returns on these types of investments vary, but most of them gain more from capital growth than dividends. Below is a little more info on each.
1. Hedge funds
Hedge funds are an alternative to bonds and equities. They use leverage and can be very profitable if successfully managed. Hedge funds typically charge a management fee plus an incentive fee. Management fees can range from 1% to 5%, while incentive fees can be 20% or more of the profit earned by the fund (also known as the ‘carry’). Hedge funds use different strategies to make money for themselves and their clients.
2. Venture capital
Venture capitalists invest in startups or already established companies that have growth potential. They help these companies grow by providing capital and expertise. In return, the venture capitalists seek to either receive dividends from the company or sell their stake for a large profit when these companies go public.
Commodities are goods that are not directly traded on financial exchanges, such as gold, silver, cotton, pork bellies, wheat, and oil. Instead, they are indirectly traded on financial exchanges through derivatives. Their prices depend on their demand and supply.
4. Antiques, art, and wine collections
Antiques are rare objects from the past valued for their beauty or cultural significance. Examples include furniture and jewelry. Art includes paintings, drawings, sketches, threadwork, and other forms of artistic output. And wine that has been aged for a long time (think decades) can be very valuable to wine collectors.
5. Real estate
Real estate investments require more money as property is more expensive to buy than stocks and bonds. There are two types of real estate investments:
- Residential real estate
- Commercial real estate
Residential real estate is property that people live in. Your family home, for example, could be classified as residential property. However, real estate meant to fetch rental income is known as commercial real estate.
When you finally move out of your parents’ house into your own apartment, the complex you live in could be classified as commercial real estate. When you buy office space and rent it out to small businesses, that’s also commercial real estate – like any WeWork building.
Real estate values fluctuate based on supply and demand. If no one wants to buy your house, you might have to reduce the price a lot to sell it, possibly at a loss. Conversely, if you’re seeing lots of interest based on what’s inside and outside the house (say, it’s 3 balconies and great location), you can sell it for a lot more.
Just like bonds and equities, real estate has two types of returns: rentals and capital appreciation. If you bought your house for $150,000 three years ago and it’s now worth $300,000, that’s capital appreciation at work. If you own a bachelor pad and decide to move out to a bigger house, you can lease your unit out for rental income.
Real estate in urban centers is generally pricier than real estate on the outskirts. This is because city-living is convenient thanks to close access to schools, jobs, and malls. Since living on the outskirts means a greater distance to these places and amenities, property prices are generally lower.
What is diversification in finance?
It is never a good idea to put all your eggs in one basket. In finance, diversification means putting your money in different investments to reduce the risk of losing it all in one go. With diversification, mixing asset classes that don’t ‘move together’ (i.e. assets from different classes) is the best approach.
For example, if you decide to buy Microsoft stock, property in Detroit, and a Van Gogh art piece, you would have diversified your portfolio among 3 different asset classes. If the Detroit property’s value fell due to an increase in neighborhood crime, this would not affect your Microsoft stock price or the value of your artwork. Similarly, if there was a recession and both the Microsoft share price and your property’s value fell, your art’s value might remain protected. This is because these asset classes hardly move together (i.e. they have low correlation).
Diversity doesn’t only apply to asset classes. You can also diversify your portfolio across:
- Geography: By having assets in China and America, for example.
- Industry: By investing in the mining and healthcare sectors, for instance.
- Companies: By buying shares in two industry players, e.g. Standard Bank and Goldman Sachs.
Owning a business venture is also an investment that counts towards diversifying your portfolio. If you own Amazon shares and run a digital marketing agency, the agency might continue to make you money even if your Amazon stock price drops.
Diversify your income today
Take time to assess what you own (and what you owe) to determine how diversified your portfolio is. If you don’t own any assets just yet, start small by buying low-cost stocks and bonds or buying into a mutual fund. As your portfolio grows and returns a profit, you can use that money to invest in different sectors, countries, and asset classes.
Beyond assets, you can also diversify your income stream. Are you an asset manager who loves swimming? Teach swimming lessons on the weekends. Perhaps an IT manager who loves taking photos? Shoot portraits on the side. This keeps your financial eggs in different baskets and ensures you can survive a downturn in any sector.
If you’re not sure where to begin with all of this, reach out to a certified financial advisor to help you start, grow, and diversify your portfolio today.