After committing to saving some money, the next question we need to answer is where should we put it? An investment can take a number of different forms, from a simple savings account at a bank (cash), to stocks and shares.
We can categorise different types of investments into broad groups of asset classes (e.g., cash, bonds, stocks and shares). We will review each of these asset classes individually, and consider how to build a balanced investment portfolio containing a mixture of different assets appropriate to specific individual circumstances.
The proportion of their savings that an individual allocates to each of these asset classes is what we refer to as asset allocation. [See asset allocation]
Without the confidence to explore a wider array of investment opportunities, the default savings vehicle for most people will be cash savings. Some easily accessible cash is necessary for everyone. However, by putting too high a percentage of your investable assets (the available money you have to save) into a simple savings account will very likely lead to a worse outcome than could otherwise be achieved over the vast majority of time horizons (how long you are saving for).
For this reason we will primarily concentrate on the non-cash investment products, such as stocks and shares.
Different Asset Classes
- Cash – simple savings accounts held with a bank or building society. Usually this is the lowest risk, and lowest return investment product available. [See: cash]
- Bonds – a bond is a commitment by an issuer (borrower) to return the investment proceeds (the initial amount borrowed + interest) to the investor. Since the interest on the bond is pre-defined this is known as a fixed income product. Borrowers can include countries and companies. [See: bonds]
- Stocks and shares (equities) – the stock market is made up of publicly traded shares of individual companies that permit the shareholder (investor) to share in the performance of the underlying business. By purchasing a share in a listed company you become a part owner of that business. [See: stocks and shares]
- Commodities – commodities are natural resources (physical products) such as gold or oil, which can also behave as an investment. [See: commodities]
- Property – different types of property (or real estate) make up their own asset class that can be invested in. There are two primary types of property: residential (homes for people to live in), and commercial (e.g., office or retail space). There are several different ways in which you can invest in property. [See: property]
- Alternative investments – this is the broadest asset class, which ranges from hedge funds (an investment company that will invest money on your behalf) to more obscure investments such as art or fine wine (just be careful not to drink it if you intend to hold it as an investment!).
Investment Properties
It is important to bear in mind that different asset classes will have different properties, such as different levels of risk/reward, or different levels of liquidity (i.e., how easily and quickly the asset can be converted into cash).
For this reason it is important to build a portfolio that contains a suitable balance of different asset classes, and different products. [see: diversification]
Investment Risk
Investment risk [see investment risk] is the risk that an investment could underperform, including the risk that it could return less than originally invested.
It is entirely natural for an individual to want to avoid investment risk – people are generally risk-averse. If there is a risk of losing any money it is inevitable that people will be cautious, and so individuals will typically seek to avoid it altogether (particularly if investing isn’t something they know a lot about). [See: attitudes to risk]
However, what if we turn this on its head? There is a significant opportunity cost in NOT investing (see: introductory video / the power of investing).
When holding an investment an individual is compensated (financially rewarded) for bearing this investment risk. With a portfolio appropriate to the individual (designed for a particular time horizon), investment risk can be greatly reduced, and so the likelihood of a good performance over time is actually very high. [See: diversification]