Ok, now that you’ve opened up a brokerage account and call yourself an investor/day trader/A$AP Buffett at holiday parties, let’s dive into the types of assets you can invest in. This is important for those of you dedicated to maintaining a polished portfolio that you will track regularly. It helps to organize your investments and piece together the larger picture of your portfolio—your strategies and investment goals. Chances are you probably think investing means giving money to in exchange for stocks with the hope of future price appreciation. In essence, this is the simple plan of investing—but a successful investor always has a REAL plan with their portfolio. It can be aggressive growth, gradual growth, dividend accumulation, index-tracking positions, etc… Whatever your wildest dreams are for your portfolio, it is critical to understand and distinguish asset classes from one another. It also adds to your arsenal of financial jargon to use when flirting with that cute boy or girl from AP Econ or Intro to Macro…We all know Suzie falls head over heels for those mortgage-backed securities! Meanwhile, the three main asset classes are cash and cash equivalents, equity, and fixed income.
Cash and cash equivalents are either straight moolah, a savings or checkings account with some financial institution, or any alternatives to cash. Some examples are CD’s (certificates of deposit), money market vehicles such as Treasury bills. The thing to take away from cash equivalents is that they are extremely liquid. Liquidity measures how easy and quick it is to convert your asset into cold, hard cash.
For example, converting your personal check into cash is a much faster process than withdrawing money from your investment in a hedge fund, which only allows deposits and withdrawals once or twice a year depending on the fund.
Investors save up cash and cash equivalents if they are hesitant to invest in capital markets because this asset class avoids market risk—risk associated with the ups and downs of financial markets. So this is where you store your savings if both the stock and bond markets are failing. If you don’t trust the markets, cash and its equivalents are a great storage place for your money. However, there is a huge opportunity cost to holding cash, and that is the potential for infinite capital gains from investing that money in equity or fixed income markets. Again, it all depends on Who You Are.
So where does equity come into play? Equity is a stake in a public company represented by common stock issued by that company. In layman’s terms, equity is ownership. If you invest $1000 in Facebook (FB), you now own $1000 of the social media giant’s $64bn market capitalization…you’re a baller! Equity is the most aggressive of the three main asset classes because the entire equity market is based on the notion that companies’ future earnings will improve—this is obviously subject to the flux of financial markets and global economy. We never know what will happen in the future. Unlike bondholders, who are the first to be paid interest by companies and governments in the event of bankruptcy, stockholders receive dividends from company’s generated income as a token of gratitude for betting on the company’s future gains. This facet of equities, dividends, drives many investors to purchase stocks that pay hefty dividends every quarter. Personally, I have never been a fan of dividend stocks because I believe stock prices reflect their underlying companies’ fundamental values—a characteristic of value investors. But that’s just me.
Equities come in the form of common stocks, as well as mutual funds and ETF’s that pool individual stocks. For most of you who will be investing passively, mutual funds and ETF’s are great ways to pass on the time-consuming task of due diligence (investment valuation) to money managers for a fee. Mutual Funds tend to be expensive because of their actively managed property, but ETF’s just track indexes so there are no high entry costs and they are also tax efficient. Speaking of tax efficiency, capital gains tax is CRUCIAL to those of you interested in actively trading stocks. If you do not hold your positions for at least a year, you are subject to approximately 30-40% short-term capital gains tax. If you keep a stock longer than one year, you only have to pay approximately 15-20% tax on your gains depending on your tax bracket. There are many strategies to minimize these taxes and that is a large part of the job of a Private Wealth Manager.
Fixed income is also crucial to your portfolio. It is where you find bonds…and I ain’t talkin’ ‘bout Barry. Bonds are essentially IOU’s issued by governments, municipalities (states, counties, cities, towns, school districts, hospitals, highways, airports, etc…), or companies (corporate bonds). Bonds are safer investments than stocks or equity because their value is already established, or fixed. If you don’t know what a bond is, it is a debt obligation issued by institutions looking to finance certain projects or ventures. The NY Housing Development Corporation municipal bond uses investor money coming from bond purchases to erect housing buildings in the Big Apple. Meanwhile, we are witnessing a situation where investment is fleeing from Detroit municipalities because of their recent call for bankruptcy. Investors are scared that their money will never be seen again, so they are cutting their losses now. It is interesting and enlightening to connect your personal knowledge with current events.
Since fixed income investors are owed money, bonds seem more stable of an environment than stocks or alternative investments. However, it is not as safe as cash because there is a risk associated with credit—default risk. This is basically the chance that the issuer of the bond will not be able to pay you back your principal and interest (for lending them money) at the maturity date of the asset. The safest of fixed income investments is the Treasury bill, which is a bond issued by the United States government. It is generally accepted that America is too important and stable of a nation to go bankrupt and default on their credit owed to bondholders. Explaining bond structure and its relationship to interest rates is a completely separate topic that I will let your Economics professors cover. If you are more conservative, your portfolio will be filled with more fixed income than equity, and vice versa. These are not the only types of assets though.
Of course, there are dozens of other types of investments, but these are the main three asset classes that most investors will deal with. This is simply because most investors are passive and do not have the time to pay attention to alternative investments like commodities, private equity funds and hedge funds (for you Mark Cubans out there), MLP’s (mastered limited partnerships), real estate or physical assets like art. To profit from these forms of investment you must dedicate hours to researching what these investments offer for your portfolios. Usually, they are included in portfolios to provide additional diversification, hedging abilities, exposure to previously unavailable markets, and significant capital appreciation. Due to the exhaustive list of these alternative investments, I will let interested individuals come across their own findings for these very interesting assets.
If you are serious about your investments, asset classes become your best friend. Let’s say you create an Excel spreadsheet listing all of your assets. You need to organize your investments appropriately to guide yourself to your portfolio thesis (investment goal). If you are looking for exponential growth from your assets, you may structure your portfolio to mainly contain equities in sectors like Technology, Telecom, and Emerging Markets. For growth, you will also want to reduce the exposure to fixed income and cash, so understanding which asset class ties to which goal is invaluable. With a distinguishable list of investments, you understand when and what to get into or get out of at what trigger events or dates.
An example of this is the all-too-notorious earnings announcements for each quarter. Facebook’s (FB) was Tuesday, which revealed Q2 revenues that exceeded expectations, bumping up their share price by nearly 13%. So if you have been keeping up with Facebook or any company and know a quarterly announcement or catalyst event is coming up, be confident with what you know and take a firm position in your portfolio. From my very lengthy year of investing, I have quickly understood that weak positions do not produce enough profit for aggressive investors like myself.
I hope this piece clarifies the definitions of various assets and why investors choose some instead of others. I wanted to shed light on the fact that capital markets do not just comprise of stocks, and that hundreds of vehicles exist for you to take advantage of the trends of certain companies, sectors, countries, regions, and entire markets—both their upsides and downsides.