Today I am going to teach you about “asset classes”, which is the most primary lesson every investor should go through. Understanding asset classes is very important for an investor because when you invest your money in any financial product, then in the background, it goes to a certain asset class only.
The world of personal finance has hundreds of financial products, which makes everything confusing for an investor, but if you understand which asset class it belongs to, then this whole world of personal finance will sound easy to you.
So if you are confused about whether to invest your money in a fixed deposit or a mutual fund? Or into gold ETF’s or PPF? How do you decide?
Just ask – “Which asset class does it belong to?”
Is a fixed deposit in bank better or a PPF would be the right thing for you, this all questions might seem to be confusion to you if you do not understand which asset class they come from? So in this article, we will go deeper into the basics of investing and help you to get stronger into the primary level information.
What is the meaning of Asset Classes?
Asset classes can be seen a big basket where all the financial products belonging to that asset class share a common characteristics. Things like risk, returns, liquidity and various other parameters are similar.
For example, a Fixed Deposit and PPF is different financial instrument, but at the deeper level they both are secure products, you do not lose money in these products, their returns are also predefined and there is predictability in their returns.
Can you see that both FD’s and PPF share some common characteristics? It’s because they both belong to the asset class “Fixed Income”.
Here is a video which gives an introduction to asset classes
In the same way, an equity mutual fund or direct stocks, both are different financial instruments from high level, but inside they both are high volatility instruments, and have potential to multiply your investment amount many times in short period of time, this is because they both belong to same asset class called “Equity”.
Below is a snapshot from Karvy website which shows you the wealth distribution of Indian investors in year 2015.
There are 5 asset classes
While there is no standard list or category of asset classes, widely it’s accepted that there are 5 types of asset classes namely
- Fixed Income
- Real Estate
Every financial product you come across will fall into any of these 5 asset classes only. Each of these asset classes has their own set of behavior and they represent something unique about them. The chart below shows you financial products belonging to these asset classes and what these asset classes denote
Asset Class #1 – FIXED INCOME
Let’s start with the most famous and favorite asset class of India, which is “Fixed Income”. Fixed Income asset class refers to the class of financial products where your investment amount is more of less protected and the returns are either fixed or predictable to a great extent. There is almost no/less risk in these products which are from fixed income asset class.
Investing in fixed income asset class is like lending your money to someone with assurance of return with predefined returns. So when you make a fixed deposit in a bank, you are not exactly “investing”, but lending your money to the bank with a promise that they will return back your principle amount along with a pre-defined interest.
Fixed Deposits do not beat inflation
Even if you are getting 8-9% return on your fixed deposits, many people do not realize that it’s the pre-tax return. As Fixed deposits are taxable (and every other debt instrument), once you pay the tax on the returns, the post tax returns are only in range of 6-7% and if you adjust the inflation of 8-10%, you are actually getting a negative return on your fixed income investments.
Livemint has done a story on this topic in a detailed manner which you should read.
Risk is less in Fixed Income Asset class
All those who want to get a fixed return and do not want to take any risk should choose this asset class. It’s a human nature to seek assurity, and given that fact, fixed income instruments are big hit. No wonder Fixed Deposits rule the world of investments, It’s a simple and easy to understand financial product.
Same goes with PPF , NSC, recurring Deposits and various govt bonds or debt mutual funds. However note that this asset class does not beat inflation or nearly matches it, hence over a long term, while your investments amount will become bigger in number, the purchasing power will remain stagnant or might drop. So this asset class is to only protect your money, not grow it.
Asset Class #2 – Equity
Equity asset class is an interesting asset class and slowly getting more and more acceptance from last 1-2 decades.
Equity means ownership
So when you invest in equity, it means that you have bought ownership into a business. For example, when you buy stocks of Infosys or Reliance, you become a small owner of that business.
Even the RSU and ESPP which you get from your company makes you a small investor in the company and that’s “equity investment”
Now obviously when you invest in business, you get a % ownership. And if that company becomes big someday in future, your overall worth also goes up. But there is a problem, the business grows only over time and in between there are ups and downs and that reflects in the stock price of the business/company.
If you look at all the rich people today (really filthy rich), it all happened with equity investor. Someone either opened their own company or invested in some company which was growing and held it over long term.
Equity Investing works in long run
Below is the 10 yrs return chart for various years for sensex. You can see that most of the times sensex has given more than 12% return (much more than that actually) every 4/5 times. This is since the time sensex has been into existence.
Because the equity returns are very volatile, most of the people refrain from mutual funds investment or investing into direct stocks, but they are the real wealth builders for any investors. There are mutual funds from various Asset management companies which have proven track record for building wealth for its investors.
Asset Class #3 – Real Estate
Real estate, as we all know refers to physical space, or physical structure like land, residential flats, commercial spaces etc. These spaces are either used for living purpose or for doing the business and generate income. Should one invest in real estate or not is a topic of debate and I am not getting into that right now.
Over the last 2 decades, the real estate asset class has got tremendous interest from investors. Everyone wants to now own a home and real estate is very sought after asset class. As the country develops and expands, we see many upcoming areas in all cities and a location which was considered outskirt of the city becomes a very important location in the city and we see some amazing returns.
However the fact is that we always hear the “good” stories and never the bad stories where one got bad returns from real estate or lost their money.
Returns from Real Estate
Real estate market has cycles of ups and downs and returns from real estate can be very volatile and can depend on various factors like city future, govt policies, political situations and many more. For example if you look at Hyderabad, the returns in real estate has not moved anywhere in last 7-8 years and we are talking about average returns here.
Bigdecisions.com has done a study based on NHB Residex to compute the real estate returns in various Indian cities from 2007-2014 and below were the results.
I am in on way saying if real estate is good or bad. All I am trying to do is make you aware about the characterics of real estate as an asset class. You need a high ticket size for investment, the market is not regulated at all (only recently the regulation has been made) and it’s more of less one side market with lot of opaqueness.
Asset Class #4 – Commodities
Commodities refer to various types of physical goods or products which we all can buy and sell for various uses. Gold, Silver, Copper, Rice, and Oil etc will be counted under this asset class. The price of these products depend on demand and supply in the market.
Commodities are for “Trading” and not investing
With my limited understanding, I came to the conclusion that commodities are not for investing for long term, but mainly for trading, where you can benefit of the market cycles and predict demand and supply moves and get a profit or loss.
Returns from the commodities can be very volatile and each commodity has its own market and dynamics.
Only a handful of commodities like Gold or Silver can be invested in for a very long time because they can be stored without losing their usage. A common man can’t store other commodities in the same way, hence trading them for short term is a feasible option.
Asset Class #5 – Cash
When I say “cash”, I don’t just mean the hard cash bundles, but also the money lying in your saving bank account, or liquid mutual funds. I will refer all of these things as “Cash”.
The best thing about cash is that it gives you freedom to “buy” anything you want instantly. You can buy a car, a house or a phone or invest your money in other asset classes.
The freedom you get with cash is very high and that’s one reason why most of the people prefer to hold a lot of cash. Also the cash cannot be tracked (unless it’s several multi crore rupees) and many people keep their black money in form of cash.
It’s not uncommon to see many lakhs lying in a saving bank account just because the investor thinks “What if something goes wrong?”
However cash has one problem, it does not fight inflation at all or very little. The money lying in saving bank account just earns 4% and that does not help you as an investor.
Which asset class you should invest into?
Where should you invest your money? This question can only be answered if you are clear about your requirements like how much risk can you take and how much return do you expect out of your investment?
Are you ok with locking your money for several years or not? I have made a simple table which compares all asset classes on various parameters.
I hope this article gave you the high level understanding of all asset classes and cleared your basics. Please share which is your favorite asset class and why?