25^th December, 2020 by elmads

INTRODUCTION

As investing has been gaining popularity, the number of individuals investing a part of their salary to various financial products, such as stocks, bonds and real estate are increasing as well. Yet, there are still somehow, confusion between these investment asset categories. “Where does the confusion comes from, you say?” well it comes from the common questions people ask. “Where should I invest my money? is it in the stock market or real estate or maybe in commodities for a better quick gain.”, “ I want my invested money not to go up and down in amount that much while still having a steady monthly income from it, so what are your thoughts about stock XYZ?”, so on and so forth.

These uncertainties come from not knowing that the investment universe has actually 5 major asset classes. Each class has a corresponding purpose that can fit with our own objectives. By learning and understanding these 5, It will significantly help us to understand what every asset class does, what will be applicable for our financial objectives, and most importantly to give us a clearer picture of the world of investing.

As what I have discussed in my “Basic Financial Planning Guide, Part 1” in investing under wealth accumulation section. Investing is knowing 1^st what are our investment objectives, 2^nd the time horizon of our investments before needing the money and 3^rd the level of risk we are willing to take. Lastly, knowing all the advantages and disadvantages of the 5 asset classes, as this will show us which one will be applicable to our investment goals, time, effort and personality.

Blindly investing all of our money into stocks just because it can give us a massive amounts of return is a recipe for disaster. “Why is that?” well for one, almost everyone that I know, invest only in stocks for the sake of that monumental investment returns. But then, when I ask them what are their objectives, they either do not know or some of them will just say for retirement, yet when the market crashed last march of 2020 (COVID19 Pandemic Stock Market Crash), they sold their stock positions because they freaked out and got scared. That is where knowing our own level of risk is important and knowing if we can handle the risk that the specific asset class possess.

Without further ado here are now the 5 asset classes. Namely Cash, Fixed Income, Equity, Real Estate, and Commodities.

CASH

Yes, cash is an asset class by its own right. Included here are the money in our savings account, digital cash in our own online wallet and our physical paper cash.

Cash represents a great freedom of choice to its owner, because people can purchase whatever products or services they want in exchange for cash.

The greatest advantage of cash is its liquidity, this is the accessibility and its power to be taken as a payment in exchange for goods and services. Remember in our financial history, our ancestors used a product as exchange for another product, which is called barter trading. This did not work perfectly in the past.

Here is why: if we would like to purchase a basket of apples, but we only have 1 cow to trade, how will we be able to do it? certainly, we cannot cut down a cow to equal the worth of a basket of apples we want to buy. This is because, firstly, there is no benchmark amount for the trade to take place and secondly, cutting down a portion of the cow is just pure craziness. Cash made things easier as it quantified and gave a corresponding transaction amount for goods and services.

Due to cash’s greatest characteristic which is its liquidity, people have coined the popular term “Cash is King”. This is also referred to taking advantage of great deals in the markets, due to our liquidity to purchase other assets while they are at an undervalued price.

In contrast, The main disadvantage is Cash is its buying power, as it decreases overtime, due to inflation. The products and services that we could buy for let’s say 50 GBP bill today will only be able to buy what a 20 GBP bill could purchase today, after a few years. That is why Cash is only kept for emergency purposes and for short-time horizon purchases, which is usually 0-3 years. This is because the decline in our buying power, due to inflation will not be very significant for that 0-3 years time span, unlike if we hold cash for more than 10 years.

FIXED INCOME

This asset class is considered a low-risk security, because it gives stability on our invested capital. Fixed income is also know as a debt instrument. I know, as a reader of my blog you are aware that I do not like debt that much, but this is not us who are getting into debt, it is them, the government and companies.

In Fixed Income asset class:

• We will be the one loaning the money (called as Par Value/Face Value)
• For a certain amount of time (either months or years and this is called Term/Maturity)
• With the expectation to receive a regular fixed payment based on both the Coupon Rate (also known as Interest Rate Payment) and on the amount of money we gave to the government or companies as a loan (Par/Face Value).
• At the end of the term contract, we will still be receiving the initial capital we loaned to them, plus the income that we have received throughout the years.

Below is an example of a bond holding which is the most popular Fixed Income asset.

We receive a specific amount of money which is paid to us regularly in a given set of time and interval, hence the name “Fixed Income”. The amount that will be paid to us, until the end of the contract term will very easy to project due to its payment predictability.

Is there a risk in investing in fixed income? There certainly is, it depends where we invest our money as there are categories of fixed income, the popular 3 are government/treasury bonds, corporate bonds, and certificate of deposit from banks.

• Bonds – they are said to be safer when we invest in government/treasury bonds as they are less likely to default and go into bankruptcy compared to companies and municipalities. If a government becomes insolvent then that means that the country it governs is in a real deep problem as well. Furthermore, corporate bonds are debt contract taken by companies from interested investors. In here, we’ll be loaning money to the company and in return they’ll be giving us coupon payments (their interest payments on debts)
• Certificate of deposit from banks – known as CDs, they usually have shorter maturity dates (months to around 5 years) and they typically have lower interest rate payments compared to bonds, but higher rates compared to savings accounts.
• Preferred stocks – Take not that this is a stock. I just added this one as it acts mostly as a bond rather than a stock equity. This is considered a hybrid instrument as it consists both equity and debt instrument. In here, we will still receive a certain amount of dividends (this is the same as the coupon payment of bonds) which is usually higher than the commons stock holders of a company. This will be paid in a given period of time same as bonds. The downside is, companies can decide to cancel dividends when they are in crisis or worse go into bankruptcy which can result for us to lose our initial capital investment

The nature for Fixed Assets are for capital preservation as the return on investments are fluctuating around 3-5% which is the same average inflation rate worldwide. This is why Fixed assets are not popular to some investors because it does not give a larger return on capital.

Furthermore, national interest rates set by the Central Banks of each countries affect the return of Fixed assets. In particular, in the year 2020, interest rates in western countries were set at the lowest level in history at almost 0%, which makes the coupon payment of bonds at around that level of 0% to 3% (depending on how long is the maturity of the bond eg, 3, 5, 10, 15 20, 30 years). This made bonds a very unattractive investment for most investors that time. If you are interested in investing in bonds and certificate of deposits, the easiest way is to look into the big banks in your respective country. Try to visit their website or their office branches.

I’ve made a 4 part Bond Article series discussing the said asset class in detail. Links provided below.

• The Bonds Asset Class
• Valuing Bonds
• What is a Credit Rating?
• Bond Laddering Strategy

EQUITY

The well liked and the star among the 5 asset classes. Why is that? well because equities are the one of the easiest to start to invest with, and it exponentially increases our wealth overtime. Imagine, we can start investing by just simply using our smart phones, downloading the app of the broker we want, registering in our own chosen broker, depositing money in it, then find a company or companies we want to invest in, and that is it.

To easy is it not? well that is the only easy part of it because equity is a complex asset class. It is true that it can make our wealth double, triple or even make it 100x larger than our initial investment. But, the same can be said for the losses that we can incur if we do not learn, do the research, apply that knowledge properly, execute our learning and have the patience to do so.

Equity is a part ownership of a corporation. Directors and the top brass decides to breakdown the company’s ownership into shares. These shares will then be sold to investors via Initial Public Offering, for financing the company’s objective, usually for growth. I have discussed this further in my blog titled, “How Shares are made and how the Stock Market works”, which gives us the narrative and background of how the market works.

In addition, when the company grows and continuously improves their operations, that can be translated into better investment returns for its investors. This is due to the fact that the value of the company will mostly reflect into its stock price, because stocks are real part ownership of a company’s earnings. This also has an opposite effect for declining companies or worse companies going into bankruptcy, which can result to a massive capital loss to their remaining investors.

We gain money from equities through 2 methods, which are “DIVIDENDS” (This is a part of the company’s net income that will be given to its investors) and PRICE APPRECIATION (when the market prices go up, higher than the initial price we bought it).

Moreover, growth of good and superb companies happen overtime which is the same for its equity stock prices. This is the reason why it has been highly advisable to invest in equities for a longer time frame.

In contrast, while this growth happens, there will be bout of ups and downs in prices, which causes equity investors to panic at times, causing them to sell their holdings at a loss rather than at a gain. Investing for a longer period in time is one of the best strategy, as market prices generally appreciates in the long haul. Below are examples of the top company in the Philippines, US & UK and their respective stock prices over a span of 15-20 years.

Disclaimer: These are not stock picks. These are for example purposes only and not an advice to invest in these companies.

The above chart shows one of top companies in each country namely; SM Investments in the Philippines, Apple Inc. in the US and AstraZeneca in the UK. As depicted there are volatility in the market prices especially over a short period of time, yet in the long run it goes upwards, as long as the company’s business operations are growing and expanding.

Equities are not bound to just company stocks, there are other investment equity variations as well, such as Equity Active Mutual Funds, Equity ETFs and Equity Index Funds. If done right, Equities will give you wonderful returns in the long run.

Alternately, equities are a very broad investment. It tackles all industries in the world, which makes it an arduous task to analyse each and every company in each industry. The time it takes to even study a company takes days, weeks or even a months depending on the company and its industry.

Below are my blogs relating to the Equity Asset class:

• Stocks & Shares
• Mister Capital Market
• The Financial Markets
• What are Mutual Funds?
• Passive and Active Funds
• Exchange Traded Fund

REAL ESTATE

This is an asset class that has a physical representation like land, buildings, and structures. There are various ways in which Real estate are used, like for living purposes and investments.

Same as with equities, real estate income are generated from two main sources, which are property PRICE APPRECIATION (capital gains) and RENTAL INCOME (like dividends but in real estate). Returns in real estate can be enormous and it can even supersede the returns of equities in a wide margin at times.

Nevertheless, before we could reach that level we need to learn and study all of the information about real estate because this is a very complex topic same as with equities. We need to consider a lot of factors in real estate investing such as:

• The country laws and regulations – Taxes play a significant role in every country’s laws. This is why it is better if we could ask for help and assistance from a real estate advisors, if we find it complex to comprehend the information.
• The location we want to buy and build or sell – Firstly, for safety and security if we want to live in it. And lastly, the possible growth of the area. Some land can be worth more than they currently are after a few years, because of the plausibility of becoming a booming city in the future. Finding these great kinds of opportunities is what we, as investors always look for.
• The prices in the area of choice – As it is always prudent to buy at lower prices, to find good deals, and to have a better rate of return from our initial capital investment. That being said, this method takes an enormous amount of our patience, time and effort to find one. Generally, this applies for all investment asset categories too.
• or we can just ask for a real estate advisor to seek professional assistance and/or let them do the research for us instead. Nevertheless, this will require money to pay for their expertise.

On the one hand, the average yearly return for house price gains are around 6% which is definitely above inflation, but not higher than equities. That being said, if we include rental gains plus capital gains, the returns can then be boosted at around 15% annually.

Furthermore, leverage plays a key role in property investing, as we will mostly use the money from banks rather than our own money, why is that? because majority of people do not have a large sum of money for one-off payment. This leveraging strategy will definitely give an immense growth for our money, only if we know how to handle debt and have the knowledge about real estate investing.

The above line graphs are the average housing prices of two countries. Starting from left to right, the UK and the Philippines. Same as stocks, the prices moves generally up in the long-term horizon.

Just for additional information, the above charts are for rental property investors, which shows the updated average rental yields per region in the UK and per city in the Philippines. (The Gross Rental Yield (GRY) measures the gross rental income generated by a property as a percentage of its initial purchased price)

On the other hand, there are certainly downsides in investing in real estate, one of which is we need a large initial capital to enter this domain. We cannot buy one for less than 80,000 GBP/USD or at 1 million PHP. I am pertaining here to capital without debt, I know some of you are thinking that you could have an initial deposit of way less than the numbers above. That is true, but you know that I do not like debt that much, especially when it is for first time investors.

Debt plays a major role in Real Estate, I get it and a lot of people are able to gain a significant amount of money from it, which is absolutely and undeniably true. But those people studied and learned about property investing, or has a mentor/advisor, or both. I am not against using debt to finance property, the only thing that I am against and worried about is, if you do not know what you are doing. If someone is guiding you then by all means go ahead, but if not, please do your utmost best to study, learn, have the skills and the right attitude first, before venturing into this asset class.

Nevertheless, if we want to purchase a property to live in it, then certainly buy one. Mortgage is one good debt in my own opinion, but if this will be for an investment as a rental property, while you are a beginner investor and you do not have the basic knowledge, skills, attitude, no one to guide you (mentor/advisor), support and tell you what to do in your best interest, then just do not push forward with it. I am sorry, there are other asset classes to look into as your first investment other than Real Estate.

Getting that aside, Real estate has market cycles as well, prices can go up and down but are less volatile unlike equities. Property market prices are also affected by future growth of the area where it is located, political situations of the country, government policies, worldwide events and many more. For instance, in the 2008 financial crisis, house prices plunged at approximately negative 16% just because of the greediness of the banking and real estate industries that time.

That being said, property markets generally go up in the long term, same as the stock market. In addition, we need to make sure that the money we invest must be for the long-term horizon due to its nature of illiquidity. Properties cannot be sold within the day of us deciding to sell it, it takes months or even years for someone to buy it and exchange that property into cash.

There are other ways to invest in Real Estate, one popular method is through Real Estate Investment Trust (REITs), which is a hybrid of both property and equity. In REITs there will be an investment manager who will handle the raised money and invest it into different properties.

The investors trust their money to these fund managers to do the right investment decision to grow their wealth, hence the name investment trust. Investors will receive a dividend which is approximately 90% of the REITS’ net income per year, as required by most governments in the world. For example, If the REITs we are invested in received a net income of 100 million for the year 2022, then it is expected for them to give out 90 million of their income to their investors as dividends.

NOTE: REITs are also stocks, in which what you own is a piece of the real estate investment trust shares. There is a misconception that REITs are like mutual funds, where you give directly your hard-earned money to a fund manage then they’ll invest that money in your behalf, which is not the case. The structure between stocks and mutual funds are different. The former is a direct ownership of a business through owning shares of it, while the latter is where someone will invest your hard-earned money in your behalf.

The advantage of REIT is that investors will not be handling the property themselves for maintenance, tenants, and the legalities needed when purchasing a property. On the flip side, the possible returns that it can give to its investors are average, compared to when they invest their hard-earned money directly to real estate properties and rent it out.

Below are my articles relating to the Real Estate Asset Class:

• Is the home you live in an Investment?
• Home Price Appreciation can be Lucrative, depending on this one factor

COMMODITIES

It is a basic raw material or primary agriculture product that is used as an input in the process of producing refined goods. To make it simpler, it is an ownership of goods which has an end use. In particular, Hair sprays need oil, bridges need steel, pastries need wheat, a cup of coffee needs coffee beans and many more.

Commodities can be traded with other materials of the same type even if it is produced in a different area or country. For instance, oil can be traded for oil, gold for gold, and lumber for lumber, you get the point.

Commodities have 2 main categories which are Soft and Hard. Soft commodities are referred to items that are naturally grown and ranched such as rice, corn and livestock. Hard commodities pertain to resources that need to be extracted and mined like gold, steel, silver and oil. Moreover, commodities like equities have different sectors as well, which are Agricultural (rice and livestock), Energy (oil and natural gas), Industrial metals (steel), and Precious metals (gold and silver).

Generally, majority of investors who dabble in this market utilizes trading strategies than investing, because of the high volatility nature of the market. Nevertheless, we can still do a long-term investment strategy as long as we do our own research and valuations. Remember supply and demand, policies, politics, and current events highly impact commodity prices.

To give you context, during the COVID19 pandemic, when most countries worldwide went into a lockdown. This impacted the transportation industry, as it resulted into less to no land, air and water travel, hence the low consumption demand for oil. Countries that produce oil were remarkably impacted, in spite of this, they still continued to produce oil. This caused oil prices to further crash into the negative levels. This was the first time in the world’s history that oil reached the negative price territory.

As shown above, the price of oil went down as low as -39.40 USD a barrel back in April 2020.

In addition, commodities are just hard to understand especially for starting investors, because in the economics of commodities trading they have what they call the futures market. Basically, it is a contract to either sell or purchase a certain amount of a commodity like a barrel of oil, a sack of coffee beans or corn, on a specific amount of price and time in the future. Just the word “future” makes everything complicated already. There are other asset classes to start into before this, which will be easier for you to comprehend.

That being said, commodities are still a very good protection especially with precious metals such as gold and silver. They act as a diversifier of our investment because it tends to reflect inflation and it can also protect our investments when economic crisis happens.

Precious metals usually represent a good store of value and protection, it is known that the price of these metals are reversely proportional with stocks. When stocks goes down, precious metals go up and vice versa. Take note, this does not happen 100% of the time.

TABLE SUMMARY OF THE ASSET CLASSES BASED ON RISK

This table shows a simple summary of the 5 basic assets classes and their various categorical risk levels by, growth, volatility and liquidity. Others might not agree with some of my points in the chart because other investor’s strategy and knowledge about a certain asset class, maybe in an advance stage already.

These investors may have a different perception of it. For instance, some may say that the understandability of Real estate is easier than equity, or the liquidity of Commodities are higher than equity. Nonetheless, this chart is for the persons who are at the beginning level of investing, which they can use as a guide.

Investment Risks

TO SUM IT UP

Where we invest our money will always depend on our various objectives and goals, the risk level that we can handle, time horizon, the return we want to achieve and the willingness to learn. Knowing what are the asset classes are knowing which one will bring us into our goals in the fastest and safest way possible.

It is just like with different modes of transportation, a car may bring us from one point to another point, but if our journey requires us to pass into a large body of water, then utilizing a car will be impossible for this task, but using a plane or a ship is.

Investing is never about the large amount of gain that we could muster, but it is always about how accurate, precise and consistent we will be in accumulating and growing money through our own strategy. Remember that we are not just learning about investing just purely for the money, but also to attain a specific purpose in our lives that is greater than money itself.

“An investment in knowledge pays the best interest”

– Benjamin franklin

Knowledge is my Sword and Patience is my Shield,

Evan Louise Madriñan / elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.