Last update: 17.09.2024 08:35
In the last article, we explained the basics of asset classes. Investing in the capital market is less about either-or. What counts is the right mix. And we’ll take a look at that here.
Different asset classes perform differently over time. They fluctuate to different degrees and yield different returns. You can see the monthly or annual returns per asset class in performance tables. You can use this to your advantage. It is often the case that bonds rise when shares fall and vice versa.
Asset allocation across asset classes increases returns and reduces risk
By allocating your assets to different asset classes, you can improve the overall return (i.e. the yield) on your assets and reduce the fluctuation margin (i.e. the risk). Studies show that over 90 percent of investment success depends on the asset allocation across asset classes. Essentially, only the two asset classes of equities and bonds are sufficient. And it does not depend on a lucky hand that finds the right stock (“stock picking”) or even strikes at the perfect time to buy (“market timing”). You can find out why perseverance rather than market timing is required when investing in this article. Now let’s take a closer look at the differences between the asset classes. If you talk to an advisor at a bank, they’ll probably talk cheekily about asset classes. Exactly the same 😉
Equities as an asset class
With the purchase of a share, you acquire you acquire a share in a company – you become a co-owner of the company. The company invests your capital and if it makes a profit, you receive a dividend. But: the value of your shares fluctuates depending on how well the company is doing. If the company goes bankrupt, your share becomes worthless. Shares can be categorized according to countless criteria. For example, whether it is a blue chip or small cap, whether the company operates in a developed or emerging market, whether it is a growth or value stock, or which sector the company operates in (e.g. technology, basic materials, utilities, consumer goods, …).
Equities have the highest expected long-term return of all asset classes. The high expected return is associated with a high level of risk.
Bonds as an asset class
When buying a bond you lend money to a debtor. The debtor can be a state or a company that makes a promise to pay. Banks make these promises to pay tradable as bonds. The debtor must repay your capital plus interest when the bond matures. In contrast to shares, you are a lender. This means that if your debtor goes bankrupt, you will be paid before the equity providers (e.g. banks). Because the risk of being left empty-handed is lower for you than for the owners, your expected return is also lower than with an equity investment. Logical, isn’t it?
Bonds can also be categorized according to countless criteria. For example by maturity, by debtor credit rating (government bonds, corporate bonds, high-yield bonds) or by currency (domestic currency, foreign currency).
Your risk of repayment (the so-called default risk) decreases if you lend money to a good borrower for a manageable period of time. If you want to invest money as securely as possible, government bonds with the highest credit rating (reliability) and a short term (less than 2 years) are suitable. However, these do not currently earn you any interest. On the other hand, the security and availability of the money is the highest and your risk the lowest. Strictly speaking, not only do you not earn any interest, your money also loses value due to inflation – its purchasing power decreases and the real return is negative. That is the price you pay for security.
Real estate as an asset class
For real estate There are other investment options besides direct investment, i.e. the purchase of a property or condominium. A direct investment ties up a high proportion of assets in a capital investment. In addition to direct investments, you can also invest in a variety of properties via real estate shares, real estate funds or listed real estate companies (so-called real estate investment trusts, REITs). REITs must distribute at least 90 percent of their profits to their investors. This avoids the cluster risk of a single property.
Commodities as an asset class
Commodity investments are a very demanding asset class for private investors. Typical commodity investments are futures contracts on oil, coal, gold or silver. Alternatively, there are direct investments such as the purchase of physical gold or silver. However, these entail storage risks and restrictions on liquidation. The benefits of commodity investments as a portfolio addition are controversial among investment advisors because they do not generate any income and do not show any increase in value when adjusted for inflation. Nevertheless, a “Gold addition” recommended: You can view this addition as an insurance premium for your portfolio, as gold typically moves in the opposite direction to risky asset classes such as equities during turbulent market phases.
Alternative investments as an asset class
In addition to these four traditional asset classes, there is also the group of so-called alternativeinvestments.
Private equity stands for entrepreneurial investments in unlisted companies. These are risky and difficult to liquidate.
Hedge funds pursue various active investment approaches with the aim of decoupling themselves from market developments through very heterogeneous investments. Hedge funds w “beat the market”. Hedge fund managers go wild with numerous strategies and are paid accordingly….. Your risk of losses is high, as is the chance of profit. You share fully in the losses, while the hedge funds usually take a share of the profits. Not good for you.
Peer-to-peer investments. Today, technology makes it possible for you to lend money to a person or group or invest in a project without financial institutions acting as intermediaries. They come in the form of crowdlending, crowdproperty and crowdfunding, for example, and entice you with promises of high returns. You know that by now: High returns mean high risk.
Risk diversification across asset classes and investment funds
The asset classes are about spreading risk (diversification). Your money is not gambling money in a casino where you play “all in” roulette and bet on one number. Instead, you spread your money smartly across different asset classes. Remember: the mix of the two asset classes equities and bonds increases the return on your assets and at the same time reduces fluctuations in their value.
It is therefore obvious that you should not go “all in” within an asset class and bet all your money on a single share or bond. Instead, it is much smarter to spread your money across a variety of stocks or bonds, for example. So you don’t put all your eggs in one basket. Instead, you get Fund. Instead of investing money in one company or debtor, funds spread your money across numerous different investments. This means that gains or losses in one component of the fund only affect the value of the fund, and therefore you, on a pro rata basis. Instead of managing individual securities yourself, the fund does this for you. Due to their risk diversification, funds are a good option for investing smaller assets. Funds are available for pretty much all types of securities: for shares, bonds, real estate, commodities and also for mixtures of these asset classes.
Active funds, exchange-traded funds and index funds
Funds also differ according to how or by whom the components are put together. In the case of active funds, a fund manager makes decisions based on his or her experience, which units he sells or buys over time. The fund manager takes noticeable fees for this, which reduce your return. You can read in this article how negative fees slow down asset growth.
In the case of passive funds, what belongs to the index that the fund tracks is mixed in. Passive funds include exchange-traded funds (ETFs) and index funds. Both consist of securities from the same asset class and precisely track the market performance of their index. For example, there are ETFs that are based on the SMI and therefore on the Swiss market. Since it takes little effort to replicate an index and this is done automatically, you only pay low fees. You can benefit from this. Numerous studies have shown that the vast majority of fund managers are no better in their investment decisions than an index fund that tracks the market.
Summary
Ultimately, it’s about whether you believe you can beat the market and put together your own portfolio of individual stocks accordingly. We think you’re pretty brave. Or whether you’re banking on the fact that an expensive actively managed fund will also generate higher returns. We think: not a good idea. Or whether you automatically follow the performance of the capital market with passive funds (ETFs or index funds). In this article you can find out how free riding with passive funds works.
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