Understanding asset classes

The community’s financial wealth is created by the business sector of the economy. Businesses generate wealth by creating goods and services that they then sell to other businesses or, ultimately, to consumers. In order to create these goods and services businesses need access to various resources including business premises and finance. This somewhat simplified overview gives rise to the three prime building blocks of investing, referred to as asset classes:

  • Shares – ownership of businesses
  • Property – ownership of properties
  • Cash/Fixed Interest – ownership of money

In the case of the last two asset classes, the asset owner makes money by allowing others (which could be private individuals as well as businesses) to use the asset for an agreed period of time in return for an agreed monetary return, called rent in the case of property or interest in the case of money. At the end of the agreed period the property or the money is required to be returned to its owner, who is then free to enter into a new rental or loan agreement in the open marketplace

Shares

Shares, also known as ‘equities’, represent part ownership of a business, usually structured as a company. Shareholders are entitled to share in any profits that the company distributes (known as dividends). Shareholders may also expect some capital growth if the company prospers and generates increasing profits thereby rendering it increasingly attractive to other investors. Conversely, capital losses may occur if profits stagnate or fall. And of course, in the short-to-medium term share prices can move in directions completely unrelated to a company’s profitability, often due to speculative influences.

Shares can be held in public companies listed on stock exchanges, whether in Australia or overseas, or held in private companies (sometimes referred to private equity).

Property

Investments in property may involve investing in direct property, buying into listed or unlisted property trusts or purchasing property related securities. The properties themselves can be across a range of sectors including retail (like shopping centres), commercial (like office buildings), industrial (like factories and warehouses) and residential. Property investments earn rental income. The rental income that a particular property can command often grows with the economy. In that case, should the owner sell the property, other investors will often be prepared to pay more for the property than did the previous owner, giving rise to capital growth. And of course, just as with shares, in the short-to-medium term property prices can move in directions completely unrelated to their rental movements, often due to speculative influences.

Cash/Fixed Interest

Investing in cash/fixed interest securities involves lending money to the government, banks and/or corporate organisations. In return for the loan the borrower generally pays a set rate of interest for the agreed loan period. Typically, the higher the credit quality of the borrower the lower the interest rate they will be willing to pay for a loan. Also, the lender usually requires a higher rate of interest for longer loan terms. Short-term loans, up to say three months, are commonly referred to as ‘cash’, while longer-term loans are termed ‘fixed interest securities’. Once the term of the loan has expired the borrower is theoretically required to return the money, although in practice the loan is often renewed at an up-to-date interest rate for a further term. The interest income received by borrowers from lending money is generally quite stable and regular.

Loans that have not yet matured can often be bought or sold, with their market value influenced by a number of factors, including the ongoing credit quality of the borrower and the current level of interest rates relative to the rates prevailing at the time that the loan commenced.

 

Despite a somewhat bewildering array of investments that exist, most are comprised of one or more of the three asset classes outlined above. From these building blocks are constructed the seemingly never ending and often complex array of financial products that confront investors. There are now many ‘financially engineered’ structures which alter risk/return tradeoffs over different time periods or which cut and splice the income and capital parts of different investments with one another. To add further complication, there are also securities such as derivatives that allow investors to lock into set prices to purchase or sell investments, commodities, currencies and interest rates at future points in time.
Some investments are an amalgamation of many underlying investments. These can include investment companies and managed funds (such as the Third Link Growth Fund), which pool the money of many individual investors to then invest in a ‘portfolio’ of underlying investments held in one or more of the above three asset classes.



Performance and volatility of Australian shares

History has shown that an investment in Australian shares has usually performed relatively well when held over a number of years but can exhibit considerable volatility over short periods of time. As an example, in the 25 years from 1990 to 2015, the range of one year returns from the Australian share market in any 12 month period (measured on the last day of each month) was +51.4% to –40.0%. Over the same time period, when we then look at the range of five year returns from the Australian share market in any 5 year period (measured on the last day of each month), expressed as an annual compound return, we get +22.3% per annum to –4.2% per annum. This shows that volatility in returns decreases significantly the longer the holding period.

Factors influencing the Australian share market, particularly on a short term basis, can be both domestic and international and can include changes in the economic environment, in the legislative environment, in the political environment and in investor sentiment. In addition, external shocks, natural disasters and acts of terrorism can add to share market volatility as well as impact directly on individual companies.

Please note that past performance is not necessarily a reliable indicator of future performance, and that markets may experience worse results than those described above.

The indicies used to measure these numbers were the S&P/ASX All Ordinaries Accumulation Index prior to 1993 and the S&P/ASX 200 Accumulation Index from 1993 and onwards. The numbers do not reflect the extra value of imputation credits attaching to franked dividends.



Understanding risk and volatility

A dictionary definition of risk is ‘the possibility of bad consequences’. For investments, and in the broadest sense, this means the possibility that the investments you make will not result in the achievement of your investment goal(s).

It is important to note that this definition of risk depends on both the investments that you make and the goals you wish to achieve. In other words, if another investor makes exactly the same investments as you but has different goals it is possible that those particular investments could be relatively high risk investments for you but low risk for him! For example, an investment in shares might be a relatively low risk investment for someone investing to produce an income in their distant retirement years, but a high risk investment if the intention was to sell in the relatively near future to finance a house deposit.

Therefore risk can mean different things in different circumstances. For example, it can mean:

  • the risk that your investment may fail to provide the returns you expect over a particular timeframe (including unexpectedly declining in value).
  • the risk that your investment goals will not be met because the type of investments you chose did not provide the potential for adequate returns.
  • the extent to which an investment varies in value over a given period – known as investment volatility. Often investments offering higher levels of return also exhibit higher levels of volatility.

Your financial planner can help you with these considerations and in understanding and managing the risks of investing.