Seven terms you need to understand before you start investing
Thinking of investing but having trouble wrapping your head around the language of different asset classes and how they fit? Here is a simple guide to help you understand what they are and the role they play in an investment portfolio.
First the definitions of the three broad classes of investments - defensive, growth, and alternatives.
Defensive assets are lower risk investments which typically means lower returns over the long term. These include cash, fixed interest, and bonds - and often pay fixed rates of return.
Growth assets include property, equities and REITs (real estate investment trusts).
Alternatives include commodities, gold, private equity and hedge funds which often utilise strategies such as buying futures contracts and foreign currencies.
1. Bonds (fixed interest)
Typically when we talk about bonds we are talking about government bonds. This is money loaned to the government by investors for a fixed term and at a fixed interest rate. You receive regular interest payments for the duration of the bonds and will receive your principal plus the final interest payment when that security matures.
Bonds can also be sold to other investors who may pay a premium for a bond offering a higher fixed rate where interest rates have gone down. In Australia, an increasing number of corporates are also issuing bonds.
Cash assets include bank bills, bank deposits and term deposits with varying timeframes.
Commodities can provide a hedge against inflation and a store of value during times of financial, economic and political strife or during a global pandemic. Investors today have access to a wide range of commodities including oil, copper and livestock but the most popular by far is gold.
Derivatives are complex investments based on trading the underlying assets which are traded without owning the asset itself. These include CFDs, futures contracts, options and swaps. The trades are made to reflect a price in the future where the investor thinks the asset will be. This investment is complex and should only be made by people who understand fully the risks of these products.
5. Equities (stocks)
Equities, also known as stocks and shares, represent part-ownership of businesses. Companies which are listed on the stock exchange have set numbers of shares that make up their total worth. You can buy part-ownership in these companies through purchasing shares.
The price of shares can be volatile with movements driven by the company's earnings, prospects for future growth, valuation factors, investor confidence in the market and or the economy. A large number of equities also pay dividends which are relied upon by income investors.
Exchange-traded funds (ETFs) are funds often made up of shares, bonds or commodities which trade just like stocks. They are designed to be low-cost and track an index like the ASX 200 or the S&P 500, or a single asset such as gold or U.S. Dollars.
Real estate investment trusts (REITs) trade just like stocks but they offer part-ownership in businesses that hold significant property assets including commercial and office buildings, shopping malls, industrial warehouses, medical facilities, and residential dwellings.
REITs own and manage these properties on behalf of shareholders and generally pay out the rent they collect from tenants as distributions to investors.