In our two most recent articles, we discussed what it might mean to ‘retire’ and that how retirement is defined is largely up to you, but one thing that became obvious was that you need to invest in your own retirement. We discussed what it meant to be an investor and how speculating had no place in your retirement plan.
So with all this talk about retirement and investing, the obvious question then becomes: “Well where and how am I supposed to invest my money?”
The first step in understanding where and how all your future hard-earned money gets put to work and ideally compounds over time, is to understand the building blocks of all investing. You can also feel proud in that you’re about to start learning some of your first finance jargon.
So an asset class dresses well and likes champagne?
An asset class is really just a way of categorising the various ‘things’ in which you can ultimately invest your money. It is widely accepted that there are 4 main asset classes:
- Cash
- Bonds
- Property
- Equity
Each asset class brings with it its own specific risks, rewards, ‘up’s and down’s’ and characteristics that dictate how it grows or shrinks over time, and how it might suite your specific investing needs.
Our discussion on asset classes will eventually expand in future articles into things like; diversification and the notion of ‘risk vs. reward’. We’ll explain these in more detail when the time comes, but for now we need to get you to understand the basics.
Cash
Cash is pretty simple to understand. You have cash in your purse or wallet; cash in your bank account. Ideally you even have some cash in your emergency fund in the form of a money market unit trust.
Cash is generally the safest place to stash your wealth. One rand will always be worth one rand, but not always in purchasing power terms after considering the effects of inflation. This is why cash is a great place to park short-term money, or money that needs to keep its value, but over the long-term, cash is likely not suitable to provide for investment returns that will see you earning a decent real return. We suggest you have a quick read of our article on inflation to refresh your understanding on how inflation eats away at your cash.
Given that the real returns on cash are not suitable to generate long-term wealth for you, cash is not something that you’ll be investing in. You may rightly save some cash for a rainy day, but stashing all your retirement money in cash for the next 30 years is probably a bum idea.
Your return on any cash-type investment is called a “yield”. This is simply the interest that you get on your cash balance. The yield is most often variable in that it can go up and down as interest rates move.
Cash can best be described as a low-return / low-risk place to store money. As a general rule and based on past performance, you can expect to earn a real return on cash of between 0% and 1% over the long term.
Bonds
A bond is just another way of saying ‘debt’. Relax! It’s not your debt – it’s someone else’s debt.
A bond allows companies and governments to borrow money to fund their operations or spending needs. Their debt gets wrapped up nicely, allowing people like you and ourselves to invest in a portion of it.
As the borrowers, they have to pay interest on their debt from time to time. As you own a portion of the debt, you get to receive that interest.
Some bonds pay more than others. If the United States government borrows money, you will get a very low yield on that bond, since they are very credit worthy and there is arguably little risk that they’ll never pay you back. If however, Jon borrows money, you may require a much larger return for the risk that you are accepting.
Of course there are always risks. There is the risk that the person who borrowed will not pay you your interest when it’s due, or that when the time comes to pay back the entire loan amount, that they can’t! All these risks are factored in, to effectively work out what kind of interest should be paid on the bond. This will be discussed in more detail when we get around to discussing ‘risk vs. reward’.
Bonds are most easily invested in by going through a unit trust. There are unit trusts that will only invest in bonds and there are lots which invest in a mix of assets, some of which would include bonds.
Bonds generally have a higher yield than cash investments, because bonds carry more risk as we discussed above and because cash is typically a short term place to store money, whereas a company or government may borrow money over a 10 or 15 year period; long periods generally means more yield.
Bonds can best be described as medium to low return / medium to low risk. As a general rule and based on past performance, you can expect to earn a real return on bonds of between 1% and 3% over the long term.
Property
There are many ways in which one can invest in property. The first that likely comes to mind would be buying a flat and shoving a tenant in there to earn rental income. You wouldn’t be incorrect at all. See what Samuel Seeff has to say about ‘buying to let’.
Other ways to invest in property would be to buy into a property fund. Some of these funds are listed on the Johannesburg Stock Exchange and some are in unit trusts. Both work on the basis that they go out and buy lots of commercial property and earn rental income from those properties. As a shareholder or unit holder, you get to earn a share of the rental income.
No matter how you invest in property, ultimately your investment returns will be linked to a rental. Whether it is Pick ‘n Pay paying rent at a shopping centre which is owned by a property unit trust that you have invested in, or a student who rents a studio apartment that you own.
Like the returns on a bond, the returns on property are regular, likely monthly. In addition to the rental income, the underlying value of the property itself will grow over time and ideally experience capital growth.
Property can best be described as medium return / medium risk. As a general rule and based on past performance, you can expect to earn a real return on property of between 2% and 4% over the long term.
Shares or Equities
Buying a share is really just a claim you have against a company’s future profits. If you own shares in say, Old Mutual, you are entitled to a share of all Old Mutual’s future profits.
Shares are traded on the stock market, like the JSE. Simplistically put, the JSE is a place where people who want to sell shares and people who want to buy shares, can meet and conclude a transfer of shares.
One of the more attractive features of shares is that they are generally very liquid (easy to sell and buy). This means that if you want to spend R10, 000 on Pick ‘n Pay share today, you can do so within minutes. As quickly as you decide to buy them, you could sell them in seconds.
It’s no wonder most of all formalised savings and investment ultimately finds its way to shares on a stock exchange, not only because of how liquid it is (when compared to say, selling your studio apartment), but how attractive the returns have been in the past, which sets a precedent in terms of what future returns people expect on shares.
Given that there are so many shares on stock exchanges, there are a few categories or types of shares, which try and simplify things for investors. These include shares in smaller companies, medium size companies or large companies.
You will also find classifications like mining and resources shares, financial and industrial shares which really just describe the nature of the activities of the underlying companies.
The returns on shares or even a unit trust that invests in shares, are dividends. Dividends are what the company pays to its shareholders, after it has paid its own operating expenses like salaries and income tax. It’s your share of their profits.
While buying shares is potentially attractive given the higher returns that they have historically provided, it must be appreciated that with the higher returns, comes the higher volatility and risk. This means that the price of shares can swing up and down widely, depending on many things including how well the company is doing, global politics, or even how other people generally feel about the company or the global climate for investing.
Shares can best be described as high return / high risk. As a general rule and based on past performance, you can expect to earn a real return on shares of between 7% and 9% over the long term.
Don’t put all your eggs in one basket.
No one asset class is generally suitable for all your retirement investing needs. Your own specific mix of asset classes will depend on all sorts of things; including how old you are, when you plan on retiring, your own investing goals and what your own specific appetite for risk is. This is something that we’ll get into in a lot more detail as we progress in your financial journey and likely something that a financial advisor will assist you with.
Not only does each asset class bring with it its own return profile (how it generates a return) and risk profile (how risky is the borrower), but asset classes within your bigger investment pool will also work with each other, or against each other toward your investment goals.
Some asset classes are negatively correlated with other asset classes, such that when the one goes down, the other generally goes up. This ‘diversification’ or mix of assets in your wider investment strategy may offer itself as a valuable tool to shelter you from volatility.
Conclusion
Each asset class will respond very differently to changes in economic conditions, which is why having a diversified portfolio is generally a good idea.
No matter what your investment portfolio ultimately looks like, you should always try to beat inflation and earn a real return. This is the key to growing your wealth in real terms.
Now that you have a very basic understanding of where ultimately all your investing money will end up, we’ll start to explain some basic finance theory that will further set the basis for the most awesome retirement plan ever!
The Editors
Article credit: http://wellspent.co.za/articles/asset-classes-explained/
