When it comes to investing in public markets, most investors are familiar with the three traditional asset classes: Cash and Money Markets, Bonds, and Stocks. But there are other classes that may be overlooked, or that you may forget to discuss with your advisors when you meet to work on your portfolio strategy. Here’s a review of the various asset classes available to investors, to prepare you for your next meeting.
Traditional Publicly Traded Asset Classes
Cash and Money Market:
The most liquid asset class of all. Cash is cash, while money market instruments range from
- treasury bills issued by the federal and provincial governments
- bankers acceptance notes (BAs) issued by the banks
- commercial papers (CP) which are be issued by large corporations.
The terms of these “instruments” range from 1 day to 364 days.
These instruments are used when investors need liquidity or have a short-term investment horizon. In these instances, they may not want to risk any loss of capital and are happy to earn the prevailing interest rates paid in the marketplace. The interest rate earned follows a pecking order based on risk, so governments pays less than BAs which may pay less than some CP.
The risk premium an investor earns for buying BAs or CP is a function of the credit-worthiness of the issuer and is know as the credit spread over the government risk free rate. The riskier the issuer, the higher the credit spread that had to be paid to investors. The credit-worthiness of these issuers is assessed by various credit rating agencies.
Bonds or Fixed Income:
Similar to money market instruments, the bond market exists to allow investors to effectively lend money to governments and public corporations. Investors will invest in bonds issued in exchange for a stream of coupon payments over a period of time until the bonds mature. The prevailing interest rates earned on bonds is a function of central bank policy, general economic activity, inflation, and credit worthiness of the issuer.
Other risk attributes of bonds are as follows: default risk, reinvestment risk, inflation, and interest rate risk. Bond prices are inversely related to the direction of interest rates. For example, if interests go up bond prices fall; conversely if interest rates fall, then bond prices rise. The mathematical reasoning behind this relationship has to do with determining the current or net present value of all future coupon payments, which is another tutorial for a later time.
Default risk is the probability of an issuer not making good on its obligations. When an issuer fails to make its scheduled interest payments to investors, it can technically be in default. If the issuer declares bankruptcy, then there is a lengthy process that is undertaken in order to liquidate the company/entity and pay back all the lenders and investors.
Depending on the entity’s assets and collateral, lenders and bond holders may or may not get all their money back. The credit agencies also determine the creditworthiness of an issue and assign a grade to each entity and bond issue, allowing investors to determine which ones are investment-grade and which ones are not. Still, bonds have a place in everyone’s portfolio for income and liquidity. A diversified allocation of bond across issuers, term to maturity, and credit will help mitigate portfolio risk.
What is IP Private Wealth?
IP Private Wealth is a Family Office—a team of wealth advisors that operates as a round-table board of advisors. Our 360° approach to examining your goals, wealth, and future needs is what makes us the first and only choice of family office for our clients. If you’ve been looking for a way to manage your wealth more effectively, reach out to us.
Equities or Stocks:
Stocks represent ownership in a company. For publicly listed companies, their stocks trade on regulated stock exchanges allowing investors to buy and sell freely. The stock market is a live auction operating daily which allows investors to exchange shares at prices each feel the stock is worth.
The main role for a stock market is to allow for price discovery and for the ease of trading. The price of a stock or company is determined by many factors such as profitability or earnings, dividends paid, growth profile, and the financial sustainability of the company, plus many other economic factors.
In short, stocks prices typically rise when the company’s earnings are growing and/or dividends are paid and growing. Stocks can be day-traded by those who want to can use the market as a casino; or stocks can be part of a well-diversified portfolio of various companies from various sectors, allowing for a more stable return pattern over time.
Having a well-diversified portfolio allows for peace of min, is part of a prudent strategy for wealth creation over time and mitigates stock specific risk or having your all your eggs in one basket.
Other Asset Classes
Real Estate: Investors can buy property and own it directly; or, they can have indirect exposure to real estate by owning limited partnerships or REITs that are professionally managed. The question is, do you want to be a landlord or an investor? Still, owning some Real Estate is another way to further diversify risk and provide a more stable return pattern to your portfolio over the long term.
Alternative/Hedge Funds: This is an asset class that is broad and captures various types of investment strategies from Private Lending, Mortgages, Merger Arbitrage, Market Neutral, Long/short strategies, Private Equity, Infrastructure and many more. This segment of the market is growing quickly. However, most of these strategies are for accredited investors with patient capital. They all have a place in a portfolio, but it all depends on the risk appetite and liquidity needs of the investor, given that some of these strategies have restricted redemption periods.
Commodities: This asset class is not for the faint of heart. Commodities exposure is usually accomplished by way of Futures contracts, which can be leveraged, thus introducing more risk to a portfolio. To manage or trade futures contracts requires high level of knowledge, expertise and willingness to loss capital. This is not a strategy that we would employ or recommend.
In short, there are many asset classes available to investors to construct a portfolio. The best way to start and build a portfolio is with the traditional publicly-traded asset class as the foundation. From there, add other asset classes to further diversify risk and enhance returns. It does not pay to increase risk without increasing return.
Bottom line: The goal in constructing a peace-of-mind portfolio is to lower your portfolio risk or volatility overtime while maintaining or improving the return pattern that will allow you to meet your long term financial goals.
