My uncle recently bought some units of Government bonds with an average maturity of over 15 years. I casually asked – “you do know the risks involved in this investment?”. His answer left me a bit unnerved! He thought that it was a completely risk-free investment since Government never defaults. Wrong! Even if we assume that Government will never default (actually they could), the investment is risk free only if it is held till maturity. And here we are talking about a maturity of over 15 years. Unknowingly, my uncle had taken a high degree of interest rate risk. Such long-tenure bonds are highly sensitive to interest rate movements.
You must know what you are investing into. This is common sense. But surprisingly, not very common! A lot of people (like my uncle) end up investing in instruments they do not understand and/or have no idea about their risk-return characteristics.
Understanding the concept of asset classes is the key to understanding your investments. An asset class is nothing but grouping of similar types of investments. All investment options under a particular asset class will exhibit similar risk-return characteristics, will be exposed to similar types of risks and their prices will be driven by similar factors.
The 3 big asset classes are Equities, Fixed Income and Cash. We will also include 2 more asset classes here – Gold and Real Estate. Lets quickly go through each one of them:
- Equity – Investing in Equity means owning a piece of the company. You own 100 shares of Company X – you are a part owner of the Company. Equity investments are done primarily for the purpose of appreciation of your wealth (growth), although Equity may also yield income stream in form of dividends. The biggest risks are business and market risk.
- Fixed Income – this is essentially lending money out to an entity (usually a Company or the Government). Returns are the interest you earn on the money lent out. Many fixed income instruments also entail the scope of price appreciation (or depreciation!). The biggest risks are interest rate, credit and inflation risk.
- Cash – this is the money you have in your savings bank account, in your wallet or maybe even stashed away in your basement! While technically not an investment, it still is an asset serving the prime purpose of meeting immediate expenditure requirements. This biggest risk in holding cash is the inflation risk.
- Gold – this is simply holding gold either in physical form (jewellery, bars) or holding securities representing gold as an underlying such as gold ETF. Gold has been traditionally considered as a hedge against inflation and the only source of return is appreciation in gold prices. The biggest risk in holding gold is the market risk.
- Real Estate – this is owning physical property (commercial or residential) or a security representing physical properties as an underlying (Real Estate mutual funds, units of REIT). Returns are primarily of 2 types – (1) the rental on the property and (2) appreciation in the property value. The biggest risks are market and liquidity risk.
Note: These asset classes could have other risks (of varying degree) associated as well. For example, interest rate movements could impact stock prices. However, the purpose of the above illustration is to distinguish between various asset classes in terms of their “primary” risk and return characteristics.
Understanding of asset classes is the first step towards portfolio building and diversification. Once you categorise your investment into various asset class buckets, you have a fairly good idea of what to “expect” from your investments.