Investment Asset Classes: Pros and Cons
How do you decide what to invest in?
For a surprisingly large number of people, there isn’t really a process.
Most don’t invest at all for lack of knowledge or confidence.
Some invest with a huge bias for particular assets without much consideration of overexposure.
Property investing is a very good example of this as the go-to investment for many.
Often times, such investors are either overexposed to property already through their homes or even through investments in funds.
Then you throw in the fact that non-savvy property investors usually have a home bias, which compounds the overexposure.
The point about the lack of knowledge is really my motivation for writing this post.
Would you really invest in property ownership if you truly understood the pros and cons of that asset class and others?
Especially given the chances are, you don’t have a particular investment edge and therefore should really question the decision to invest in certain asset classes.
Another reason to be mindful about what asset classes you invest in is the need for portfolio diversification.
We’ve previously covered investing risks you should be aware of .
Being deliberate about what asset classes you invest in gives you the opportunity to reduce specific risks.
This reduction happens because asset classes correlate differently with each other.
The more inversely correlated they are, the better your portfolio will likely perform during market downturns.
As different asset classes carry different characteristics, they also have different return profiles.
Higher risk asset classes usually lead to higher returns on average.
Different assets also play other roles within portfolios e.g. some help to reduce the risk of inflation, whilst others are useful to have during a crisis.
This can all get confusing, given all the choice that there is about what to invest in.
This, I believe, is one major reason why most default to property investing.
Let’s now consider various investment and non-investment assets and their pros and cons.
I’ll focus on asset classes that you’re likely to hear your friends talking about.
I'll avoid cryptocurrencies and commodities for now.
We’ll look at these investment asset classes by:
Liquidity – How easily you can convert an asset into cash. The higher the liquidity, the easier you can convert that asset into cash.
This feature of liquidity in your holistic investment portfolio should not be underestimated.
Your need to easily convert assets to cash changes with age and stage of life.
Volatility – A measure of how risky an asset is. Usually, the higher the volatility, the higher the risk of the asset.
Security – The measure of protection you get when you invest in an asset.
Some have protections of up to £85k from the Financial Services Compensation Scheme (FSCS), whilst others have none.
Yield – This is a measure of the level of return you might expect from investing in an asset.
It’s unusual to think of this as an asset class, but it exists for good reason.
Cash acts as a useful benchmark for all investments. If your investments don’t beat cash, then they’ve pretty much failed.
The other importance of cash is as a destination for capital when the markets are unstable or appear overvalued.
Cash is the most liquid of all assets. You can withdraw it whenever you want if it isn’t locked away in a fixed term interest generating account.
Cash is not volatile, although the immediate risk you face with leaving your money in cash is inflation.
This reduces the purchasing power of your money over time.
Cash deposited in a bank is protected by the FSCS up to £85k per banking group.
You can get anything from 0% to ~3%, with the higher rates due to locking cash away for some time.
If you have years of life ahead of you, keeping your money is cash is not the best move.
Get that money to work in some way, but doing it sensibly over a period of time.
2. Peer To Peer Lending (P2P)
P2P sits somewhere between cash and investing in shares, for example.
It aims to give you the returns you lack with cash, but for some exposure to asset backed investments such as property.
Ratesetter is a good example of a P2P lender worth checking out.
When you invest in P2P, what happens is that you essentially convert cash on your balance sheet into a debtor (loan) balance. And for that, you generate a return.
This is dependent on the terms of the loan you sign up to and depth of the secondary market.
P2P is lower risk rated. Riskier than cash and less risky than investing in individual shares.
There is no FSCS protection, although you do get some security from the underlying assets that your money is invested in.
Such assets include property, which there is usually a 1st and 2nd charge on.
Other security features include personal guarantors, insurance and the availability of a contingency fund.
You can expect around 3% to 10% of income but with no capital gains. Returns are also relatively fixed for periods of time.
P2P does carry some risk but is a good way to give your money some good exposure for predictable returns.
Bonds represent invests you make by lending your money to either a government or a company.
These play an important role in portfolio construction as a stabiliser due to the low risk of investing in bonds.
A general rule of thumb for how much to invest in bonds is “your age in bonds”.
So if you're 35 years old, you should invest at most 35% of your money in bonds.
This ofcourse depends on your individual circumstance.
This depends on the quality of the bonds you invest in. Bonds generally have high liquidity.
Bonds traded on an exchange are easier to buy and sell compared to those traded through agents or brokers that look to match buyers and sellers.
The latter may actually not have a buyer or seller for bonds or particular days.
Government bonds or those with high credit ratings are more secure.
FSCS applies to funds and has a limit of £50k for investments per person per failed firm.
This varies as they can be negative or even strongly positive depending on how interest rates move.
Aim to invest in highly rated government bonds (UK, US, German etc) in the related currency.
You can also invest in bonds in your base currency if the credit quality is high.
Keep currency risk as an important factor for consideration.
For example, I’d avoid investing in a country with high foreign currency volatility.
Aim for the maturity of the bonds to match your time horizon as an investor.
So if you'll need your money in 5 years, then you'd want a bond that has that maturity.
Investment in equities offers you growth in your portfolio.
Unlike bonds, you own when you invest in equities, rather than being a lender.
This ownership matters because it gives you the right to receive dividends from companies you own.
The way you go about getting ownership in companies matters for at least two reasons:
- It will cost you varying amounts over time.
- You'll face varying levels of risk and therefore returns.
You can get ownership in unquoted companies directly or indirectly.
We'll cover more on these later in angel and venture capital investing.
Alternatively, you can get ownership in quoted (listed) companies.
How you get this access to ownership matters too:
- You either buy individual company shares at a high transaction cost and with high specific risk. Or
- Gain access via funds such as index trackers (index funds and ETFs – covered later). These are cheap and offer diversification.
A useful rule of thumb for how much exposure to equities that you want is:
Equity exposure = 120 – your age.
So if you’re 35, then you should aim for equity exposure of around 85% in your portfolio.
If the company or investment vehicle is listed, then you’ll have high liquidity.
You also have high liquidity with large companies where their shares are traded daily.
Highly volatile and subject to market sentiment.
This is usually what scares most people about investing in equities.
However, it is important to understand that volatility is also a gift.
This is why trading is hugely popular as seasoned traders make money from volatility movements.
This approach to making money is not what we teach on this blog. We prefer not to time the market but have time in the market.
Although saying that, market falls give you the opportunity to buy cheaper units over time.
You get no security with investment in equities. If the business you invest in fails, that’s it!
The FSCS protection that exists with investments, covers financial advice and investment firms but not shares.
Realistically anything from 3% to 10% with the possibility of capital gains.
Note though that if you were planning your future via scenario analysis, the more conservative you are the better.
3% – 6% after inflation would be a realistic range on average over time.
If equities represent only a small proportion of your overall portfolio (including your home), I’d highly recommend rethinking that.
Especially if you have years of expected life ahead of you. Nothing ventured, nothing gained!
5. Exchange Traded Funds (ETFs)
ETFs are clever inventions that I believe are an advantage of our times.
As the name suggests, it is a fund (basket of companies) that exists to track an index passively.
An index is simply a list of companies a bit like a shopping list. Examples include the FTSE All-share index or the S&P 500.
The passive part is of particular importance because it means you are paying very little for the exposure.
This is super important as far as your wealth creation over time is concerned.
Ever wondered what feeds the investment industry? Fees ofcourse!
So, the less of it you pay, the more money you have working for you.
The ETF has a price that you can buy in at, and it gets traded every day.
ETFs are also favoured for their flexibility.
Super liquid as ETFs are traded daily on a stock exchange.
Note that you shouldn’t buy and sell often. You want to go in and stay in.
Trading in and out costs money too.
This is a passive investment. So as the index that the ETF is tracking shifts, so will the price of the ETF. But this is not necessarily a bad thing as covered before.
Simply put, if the index being tracked goes down, you lose money.
If the authorised investing firm that you’re investing with goes bust, your assets are protected as they’re meant to segregate client money and assets.
Any unsuitable advice you might have taken from a financial adviser would be covered by FSCS.
Your shares or ETFs (which are considered to be shares) are not covered by FSCS.
The yield all depends on what market being tracked.
The yield you get will fall slightly short of the return from the index itself due to small (although low) fees from the ETF.
Stay on top of fees. This is extremely important over time.
There is no reason why you should pay more than 1% of your Assets Under Management (AUM) if you’re passive investing.
Expect to pay anything from 0% to about 0.50%.
6. Index Funds
These are pretty much the same as ETFs except they are not traded on an exchange.
There is also another important difference – Index funds are generally simpler than ETFs i.e. you can buy them much more easily.
In addition, index funds are cheaper than ETFs because transaction costs are usually zero in an index fund.
If you want a direct comparison between ETFs and Index funds, read here.
Subject to the volatility of the index being tracked.
Same as with ETFs above.
Same as with ETFs above.
Index fund investing requires patience over a long term horizon.
You do it because you believe you cannot outperform the market, but you’re happy with the market return coupled with low fees.
7. Residential Property
This is the asset class most people invest in by default because they think they understand it.
You live in a house with rooms, and it appears obvious that buying a property and renting it out is a good idea.
You even hear people say, “nothing beats bricks and mortar”.
I don’t know about you but I hate the pain that comes with property investing.
Especially buying to let. I like the idea of flipping if you can buy significantly below market value.
However, buying to let carries significant risks and cost often overlooked:
- Stamp duty – These are very high especially in the UK. A £400k property, for example, will cost you 5.5% (£22,000) in stamp duty.
That’s £22k!!! Just think about that for a minute. How many years till you make that money back?
- Tax – deductibility of mortgage interest is pretty much gone! This kills your margins.
- Insurance – This is ongoing and doesn’t end. Building insurance and rent protection insurance.
- Maintenance – Those tenants will call you for the smallest of things. This costs money and heartache. A lot of these costs are unexpected too. Broken boilers etc.
- Economic downturn – Carrying this stuff on your balance sheet has consequences in the event of a downturn.
- Void – If you have tenants who refuse to pay, you end up taking them to court. These are very expensive not only in missed rents but also in court fees and heartache!
You get the point.
Property investing is not fun and can land you in a lot of problems if not careful.
Don’t just get involved however many times your friends tell you they have a property portfolio.
Think about returns and what assets offer you peace of mind and flexibility.
How else could you gain exposure at a low cost?
This is highly illiquid. Once you’re in, that’s it. You can’t easily get out.
This asset class is the mercy of the local economy.
You can rely on building insurance only.
If you have a mortgage, then the property is really not yours anyway but the bank’s if you default.
Property has done well historically but is far less attractive now although that depends on where you buy.
Yield can go from negative (loss-making) to fairly profitable (10%+) in areas of high rent compared to property prices.
Think long and hard about the costs of investing in property related to other asset classes.
You’ll find that the real winners are the solicitors, estate agents, tenants but not you potentially.
If you really want property exposure, remember you already have a lot of it through your home.
I’d also think hard about what strategy to use. Buy to let vs flipping etc.
A lot of the same points apply to commercial property.
You probably indirectly already have exposure to this in any case through companies in a world equity portfolio.
8. Angel Investing
This is investing for rich savvy folks or mediocre ordinary investors.
The former will likely make some money because they’ll most likely understand how companies are valued.
With Angel Investing, you’re basically investing your hard earned money in upcoming private companies with “potential”.
So when your mate tells you she’s started a business and wants you invested as a friend, you’re basically an ‘angel’ investor if you do.
Highly illiquid. You’d need someone to buy you out at a higher value before you can get some money out.
High risk by nature of the absence of value creation and capture in such businesses.
Potentially none, although this could be a few multiples too one day.
Don’t do it unless you really know something others don’t.
9. Venture Capital/Private Equity
This is savvy active investing is usually very expensive.
Expect to pay a manager 2% annual management fee and 20% performance fee if the investments do well.
Investors in this asset class usually believe they have an edge and can unearth early stage or growth business that will make a lot of money.
People who get involved partly do it for tax reasons.
They also do it for dividends and unusual returns of 2 times their money and above upon exit.
This doesn’t always materialise, except for about 25% of such investments.
Highly illiquid unless the vehicle you invest in is listed and there is a secondary market for your shares.
High risk as investments are unquoted and often do not have product-market fit.
However, this is a highly established industry and a lot of money is made here.
None beyond the tax rebates, which help to reduce some of the risks to capital.
Anything from zero to 10 times your investment. On average, such investors typically aim for about 3 times their money.
This type of investment is suited to the mass affluent and above.
The mass affluent investor is someone who can write a cheque for £30k+. If you aren’t within this level of wealth, avoid!
Note that the real participants in this area only allocate at most 5% of their wealth to it.
To wrap up,
Why, how and what you invest your money in matters.
Don’t let property investing be the low hanging fruit asset class.
It’s easy to go on autopilot and commit your hard earned money to something that might be more pain than it is worth over time.
Take your time to consider and understand what you’re putting your money into and how it is helping you achieve your life goals.
Prioritise diversification in your overall portfolio.
This way, when that inevitable day comes when some disaster strikes, you haven’t got all your eggs in one basket.
Here are some questions for you:
What does your net worth look like today?
And how much of it is exposed to property?
How exposed are you geographically to one country?
And how much liquidity do you have?
Knowing answers to the above, what will you invest in next?
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What Investment Asset Classes Are You Mostly Invested In? And Why?
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