Different kinds of investments behave in different ways, and you need to understand what makes each asset class unique and what it might add to, or detract from your wealth building efforts.
Cash, really, is not an investment. And I don’t mean actual, physical cash in your hand in the form of bank notes and coins. I mean money held in the bank or buildings societies primarily. As we’ve seen, this money is only really useful for spending, for converting into stuff we can consume, from food to fuel to clothes to the technology that’s enable me to record the original podcast this blog series is based on.
Cash doesn’t grow; it attracts interest only. £1 will always be £1 whereas a share might be worth £1 one day and £2 the next day. Cash is the thing we convert our investments into when we want to spend that money on something tangible.
Property is the next easiest asset to understand. Most of us live in a house or flat. There are four walls and a roof. If we own that property, we know that it is tangible, it’s part of our wealth. There may be a mortgage on it, so we don’t truly own it outright yet, but we’re working on it.
We also know that generally speaking, we expect the value of our property to rise over time. We know this isn’t guaranteed, but we’re kind of banking on it being the case. If we own property purely for investment, we’ll probably rent it out to tenants and get their rent as income.
We might use that income to pay the mortgage and to maintain the place. Property is illiquid, which means it is a hassle to buy and sell. Anyone who has bought or sold a property knows what a pain in the neck it is to do, and it’s also a costly process involving surveyors, solicitors, estate agents and all sorts. There’s also no tax shelter with property investing, which is an important factor. Investors like property because it’s tangible, unlike some of the other asset classes.
Equities, AKA shares, are different again. A share is a tiny piece of a company. If you own one of those slices, you get some rights, specifically to vote in company affairs and to receive a dividend, which is a share of any profit the company makes.
Equities are bought and sold on stock markets, and the price of each share is governed by the assets the company has – its underlying value – but more so by sentiment – what investors think about that company and the economy at large. If investors are positive about the company, they will want to buy more shares, and the price will rise.
If they are worried about how the company is managed, or the current trading conditions, they may want to sell the shares in the company and if enough investors want to do that, the price of each share will fall. If a company goes bust, its shares become essentially worthless, so it is important to not hold all your money in the shares of one company or you could lose everything.
Bonds, AKA Fixed income or fixed interest securities are altogether different. Think of a bond as an IOU. If a company or a government wants to borrow money it can issue these IOUs. Imagine a piece of paper that says IOU £100 on it. I lend the UK Government £100 and I get this piece of paper in return. There are two bits of information on the IOU – the redemption date, when I’ll get my money back and the coupon, or interest rate, which is how much money the UK government will pay me each year until they pay me back the £100.
Let’s say that’s 5% or £5 a year. That’s all simple enough, but these IOUs are also traded in the stock market. So if a pension fund is looking to secure the £5 per year income to pay to a pensioner, they might buy the IOU off me, and they may even be prepared to pay me more than £100 for it, which sounds weird. Without getting bogged down in detail, bonds can fall and rise in value for similar reasons to shares, and the income they pay is also useful to investors.
After those four main asset classes, Cash, Property, Equities and Bonds, we’re down to a bunch of other asset classes, which you could call ‘others’ but which are often grouped together and called Alternatives. Chief among these are Commodities, which is code for anything which we humans consume.
Commodities include metals like gold and silver, oil, gas, and soft commodities like wheat, hops, sugar, orange juice and other foodstuffs. The value of these asset also falls and rises based on demand. A bad harvest, the wheat price will rise, a good harvest and it’ll fall.
If OPEC – the oil producing nations – cuts oil production, the price will usually rise because there’s less of it about; the law of supply and demand is at work. Crucially, commodities don’t ever produce an income, just the capital value goes up and down and often with very big swings – they are a volatile investment. There are other alternatives such as hedge funds, infrastructure and others, but these are generally niche products for experienced investors.
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