Asset classes are categories that assets can be sorted into. There are three main asset classes:
- Stocks (also known as shares or equities)
- Bonds (also known as fixed income or debt)
Other investible assets, such as real estate or commodities, are referred to as alternatives.
- Cash is considered a very safe asset. If your money is sitting safely in a bank account, you can’t lose it.
- However, inflation eats into the value of cash. This means that, in times of high inflation, it may be sensible to invest your cash into other assets to prevent it from depreciating in value.
- When you buy a stock, you are essentially buying a tiny portion of a business. If the business grows in value, the portion of it that you own will also grow in value, meaning you’ll be able to sell the stock for a profit.
- There are billions of transactions per day in the stock market. This buying and selling is what determines the price of a stock.
- If a stock is in demand and investors are willing to pay more for it than they were the previous day, the price of the stock will rise.
- A stock’s bid price is what buyers are willing to pay (or ‘bid’) for it. The ask (or ‘asking’) price is what the person owning the stock is willing to sell it for. The spread is the difference between these two prices.
What can affect a stock’s price?
- Stock prices are affected by how investors feel about the prospects of a business.
- Positive quarterly or annual earnings reports can increase investor confidence in a business, meaning investors will be willing to pay a higher price for its shares.
- However, negative press can damage investor confidence and lead to reduced demand for the company’s shares, reducing their price.
- A bond is essentially a loan from an investor to a borrower. The investor gives the borrower some money and the borrower agrees to pay it back at a specified point in the future. The investor is incentivised to provide this loan by the fact that the borrower will pay them interest on the loan.
- Bonds are known as a ‘fixed income’ instrument because the interest the investor is paid (also known as the bond’s ‘yield’) generally takes the form of regular, fixed payments.
- At the end of the period agreed by the investor and borrower the bond will reach ‘maturity’ and the investor will be given the amount of money they invested back.
Corporate and government bonds
- There are two main types of bond: corporate bonds and government bonds.
- A company or government may decide to issue bonds to raise some money through loans from investors. This money can be used to invest in personnel and infrastructure, allowing organisations to grow.
- UK government bonds are referred to as gilts. US government bonds are sometimes referred to as US treasuries.
Stocks vs. bonds
- With a bond your return is defined, which means that bonds are considered less risky than stocks.
- When you buy a stock, you’re essentially betting that the company will grow in value in the future. If the company declines in value, the value of your stock will also fall. This means that stocks are riskier than bonds, but the potential returns they can provide are also greater.
- Derivatives are a type of investment whose value derives from the performance of another asset, group of assets or benchmark (hence the name derivatives).
- A derivative is essentially a bet on how an asset will perform. The holder of a derivatives contract doesn’t actually own the underlying asset, but they stand to gain or lose money based on its performance.
- Types of derivatives include futures , forwards, options, and swaps.
- Derivatives are complex financial instruments that have become more widespread in recent decades. Asset managers often use them to manage risk in their portfolios.
Liquid and illiquid assets
- All assets can be placed on a spectrum, from liquid to illiquid.
- Liquid assets are assets that are easily convertible into cash. In simple terms, if you want to sell a liquid asset, you’ll be able to.
- In contrast, illiquid assets are more difficult to sell.
- An example of an illiquid asset might be a house. If you live in an area where there is low demand for housing, you might not be able to find a buyer to sell your house to.
- Conversely, stocks are often much more liquid because there tend to be lots of buyers and sellers.