The breadth of investment opportunities available to investors has never been greater—the range of opportunity can be intimidating at times. This article will briefly explain each "category" of investment securities and the rationale for investing in them.
In finance, these “categories” are called asset classes, and each refers to a different group of securities with different exposure. The major asset classes include:
- Equity or “stock” is fractional ownership of a company.
- Fixed Income includes debt securities such as bonds.
- Commodities are physical—usually relatively raw—goods that come from the earth such as oil, cotton, gold and soybeans.
- Alternatives include nontraditional—often esoteric—investments related to volatility, credit spreads, inflation and more.
- Currency investing includes the currencies of countries around the world.
Each asset class offers its own relative advantages and disadvantages, and each can be part of a well-diversified portfolio. Let’s examine the rationale behind each asset class.
When you buy a company’s equity (“stock”), you become a partial owner of that company. As such, you have the right to vote on key decisions, such as the members that comprise the company’s board of directors. You also have a right to the dividends that the company pays, so you can sit back, relax and collect a portion of the company’s earnings without ever going to work.
Still, these aren’t the main reasons investors choose equity: They do it for capital appreciation. At their core, equity investors believe they’ll be able to sell the security at a greater price than that at which they bought it.
One way that companies raise money is by issuing debt securities such as bonds—essentially investors loan the company money. In exchange for loaning money, the company makes regular, fixed payments to its lenders. It’s these regular, fixed payments that give “fixed income” its name.
Fixed-income investing is generally less risky than equity investments, because when you loan a company $1,000, it agrees to pay back all that money at the end of the period (plus interest). There is no such guarantee with an equity investment, as it could lose all of its value. Investors usually value fixed income for its stability, capital preservation and dependable income stream.
As the world copes with an ever-increasing population and a decreasing supply of resources, the rationale for commodities investing is clear. That’s not to say profiting is easy—it’s certainly not.
As an asset class, commodities are valued for their lack of correlation to equity and fixed-income markets—in short, for their diversification benefits.
The challenge in commodities is access: It’s simply impractical to store 3 million bushels of corn. Therefore, investors often must rely on futures contracts to gain commodities access—and that introduces a range of issues for investors.
Alternative investments include esoteric investment strategies such as plays on volatility or the shape of the yield curve. In contrast to the other asset classes, these tend to be tactical tools for professionals rather than long-term investment holdings.
That said, one label doesn’t fit all, and not all “alternative” funds are short-term tactical tools. Long/short hedge-fund-style investment funds also usually fall into the “alternatives” category, and may be held over longer periods.
Currency investing is a bet on the direction of a particular currency. In ETF format, investors can currently make directional bets on currencies such as the euro, the Aussie dollar, the yen, the U.S. dollar and even currencies from emerging markets such as the Indian rupee or the Chinese renminbi.
Currency investing is not usually recommended as a long-term holding. Instead, currency funds are often used by professionals to hedge existing currency exposure or by short-term traders.
Leveraged And Inverse
Sometimes called “geared” products, leveraged and inverse funds attempt to provide exactly that: leveraged or inverse exposure to a particular index or asset. While the temptation for greater returns is obvious, investors should know that all is not as it seems. These products usually only provide the stated leverage over a single day. That means over longer periods, your returns can differ widely from the stated leverage factor. Tread carefully with these products and be sure to read up if you decide to use them.
Lastly, it’s worth mentioning this odd pocket of the market that can actually be quite useful. Asset allocation funds invest in each of the above asset classes to varying degrees. Some attempt to retain a fixed exposure to each asset class, while others attempt to emphasize and rotate between asset classes at the optimal time.
The potential range of products here is broad, so it’s difficult to encapsulate the entire market. Still, the point is that some asset allocation products shift your exposure from fixed income to equity to commodities—so that you don’t have to. Some strategies are aggressive, while others make a simple and useful glide path that shifts investor exposure from riskier equities into more stable fixed income as a future date approaches (your retirement, maybe?).
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