Welcome to the third part of our retirement planning for millennials series. In part one we looked at taking those first tentative steps into the investing world. In part two we looked at IRAs and funding your retirement.
In part three we are going to look at the different asset classes that make up a typical investment portfolio. Investment professionals build portfolios using a number of different asset classes to guard against uncertainties in the financial markets.
A professional investor does not bet the house on black. As you gain more experience investing you may want to consider building your own investment portfolio using a self directed IRA. But to do that you’ll first need to know a little more about the different asset classes that make up a portfolio.
What is an asset class?
Analysts talk about asset classes, but what do they mean? According to Investopedia “an asset class is a group of securities that exhibit similar characteristics, behave similarly in the marketplace, and are subject to the same laws and regulations.”
Asset classes fall into three main categories: equities (stocks), fixed-income (bonds) and cash equivalents (money market instruments). Real Estate (property) and commodities (gold, silver, oil, etc) can also be considered asset classes. But for the purposes of this article we will concentrate on equities, bonds and cash.
Equities are (you guessed it) equity held in a company in the form of individual stocks. Equities are the traditional way most individuals invest their money.
Stock is issued by companies as a means of raising capital. Essentially, these companies are selling part of their business to you the investor. The company then gets to reinvest this money back into the business to generate growth. While the value of your stock increases as the company grows in value.
There is of course a downside to this, what if the company does badly? In this case the value of your stock will fall and you will lose money. Because of this equities are seen as the riskiest asset class, so you should take care when deciding which stocks to invest in.
For this reason it is best to invest in an equity fund which spreads the risk over a number of different stocks. You will often here analysts talking about individual stocks as a buy or sell. But following these recommendations is a fools errand, especially for a beginner.
Stock picking is best left to the professionals, and even they are not very good at it.
Different types of equities
You can purchase stock in one of two different flavors:
Common stock is the most common type of stock issued. When people talk about stocks they’re usually referring to this type. Common stock represents ownership in a company and a claim on a portion of its profits (if there are any). Investors typically get one vote per share to elect board members, who oversee the major decisions made by management.
Common stock typically yields higher returns than almost every other investment over the long term. But as ever with investing, this return comes at a cost, since common stocks entail the most risk. If a company goes bankrupt, common stockholders are the last inline to get paid, behind creditors, bondholders and preferred stockholders.
Preferred stockholders have a greater claim to a company’s assets and earnings than common stock. When distributions are made, preferred stockholders must be paid before common stockholders.
This is never more important than during times of insolvency. When a company liquidates it must pay all creditors and bondholders before common stockholders who will not receive any money until after the preferred shareholders are paid out.
The second most important difference is that dividends are typically guaranteed, meaning that if the company does miss a payment, it will be required to pay it before any future dividends are paid on either stock.
This makes preferred stocks similar in characteristics to fixed income (bonds). Which pay a return (coupon) regardless of the underlying state of the company.
So why would anybody buy common stock you may ask? The answer is because preferred stocks don’t fluctuate as often as a company’s common stock therefore reducing the amount of capital appreciation over the long term.
Different Classes of Stock
While common and preferred are the two main types of stock, companies can also create different classes of stock. The reason for this is to give some investors greater voting power; therefore, different classes of shares are issued with different voting rights.
For example, one class of shares would be held by a select group of investors (say a group of directors) who are given ten votes per share while a second class would be issued to the majority of investors who are given one vote per share.
When there is more than one class of stock, the classes are traditionally designated as Class A and Class B. Berkshire Hathaway (ticker: BRK), has two classes of stock. The different forms are represented by placing the letter behind the ticker symbol in a form like this: “BRKa, BRKb”.
How to buy stock
The traditional way to buy stocks is through a brokerage firm. Brokerages come in two different flavors. Full-service brokerages offer advice and account management services, but charge hefty fees for the process. And discount brokerages which offer little in the way of personal attention but are much cheaper.
Most discount brokerages use online platforms which make it easy to buy and sell individual shares. But be warned, while buying and selling shares is easy, choosing which ones to buy is not. For a beginner it would be far more prudent to begin investing in an index tracking fund such as the Vanguard Total Stock Market Index Fund Investor Shares (VTSMX) which spreads the risk over a large number of shares.
2. DRIPs & DIPs
For those of you that don’t have an account with a discount broker, dividend reinvestment plans (DRIPs) and direct investment plans (DIPs) are a great way to get started.
DRIPs and DIPs allow shareholders to purchase stock directly from the company. DRIPs are a great way to invest small amounts of money at regular intervals. So forgo your daily Starbucks and invest the money in a DRIP account instead. You’ll be amazed how such a small amount can accumulate over time.
Direct Investing is a great place to find out which companies allow you to purchase stocks directly.
Fixed income refers to any type of investment under which the borrower is obliged to make payments of a fixed amount over a fixed schedule: for example, if the borrower has to pay interest at a fixed rate once a year over ten years, and to repay the principal amount on maturity.
Fixed income investments are typically issued by large corporations and governments. The problem these institutions face is that they typically need far more money than the average bank can provide.
The U.S. government for example currently has $17.6 trillion of outstanding debt which is more than the combined market capital of the entire S&P 500.
The solution is to raise money by issuing bonds (debt) to a public market. In this way thousands of investors can each lend a portion of the capital required. The organization that sells a bond is known as the issuer. Really a bond is little more than an IOU given by a borrower (the issuer) to the lender (the investor).
In return for putting up the capital, the issuer of the bond must pay the investor something extra for the privilege of using his or her money. This “extra” comes in the form of interest payments, which are made at a predetermined rate and schedule. The interest payable is often referred to as the coupon.
The date on which the issuer has to repay the amount borrowed (known as face value) is called the maturity date. Bonds are known as fixed-income securities because you know the exact amount of cash you’ll get back if you hold the security until maturity.
For example: Let’s say you buy a bond with a face value of $1,000, a coupon of 8%, and a maturity of 10 years. This means you’ll receive a total of $80 ($1,000*8%) of interest per year for the next 10 years. Actually, because most bonds pay interest semi-annually, you’ll receive two payments of $40 a year for 10 years. When the bond matures after a decade, you’ll get your $1,000 back.
Debt vs equity
There is an important distinction between bonds and equities. By purchasing equity (stock) an investor becomes a part owner in a corporation. Ownership comes with voting rights and the right to share in any future profits. By purchasing debt (bonds) an investor becomes a creditor to the corporation (or government).
Being a creditor has its advantages, because you have a higher claim on assets than shareholders do: should the company go bankrupt, bondholders get paid before shareholders. However, on the downside, bondholders do not share in the profits if a company does well – he or she is entitled only to the principal plus interest.
How to buy bonds
The easiest way to buy bonds is through a full service or discount brokerage. You can also open an account with a bond broker, but be warned, most bond brokers require a minimum initial deposit of $5,000. If you cannot afford this amount, I suggest looking at a mutual fund that specializes in bonds.
The final asset class is cash equivalents: Sometimes you’ll hear analysts talking about holding cash. They are typically talking about cash equivalents and not hoarding dollar bills under the mattress.
Cash equivalents are investments that can be readily converted to cash. Common examples include commercial paper, treasury bills, short term government bonds, certificate of deposits (CDs), and money market holdings. To be considered cash equivalent the investment should satisfy the following criteria.
- The investment should be short term with a maturity of less than three months. If the asset matures in more than three months it cannot be classified as cash equivalent.
- The asset should be in a highly liquid market, with buyers constantly available.)
- The market price of the asset should be publically available and should not be subject to significant fluctuations.
- There should be very little risk of changes in the assets value. Equity shares cannot be classified as cash equivalents. But preferred shares purchased shortly before the redemption date can.
To sum-up, cash and cash equivalents are the most liquid assets an investor owns. The idea is that these assets can be quickly converted to other assets when the need arrises. Such as when market sentiment changes from a bull into a bear market. During periods of uncertainty like this, you would typically want to hold more cash equivalents than at any other time.
That brings to a close our article on asset classes. Next time we will look at how you can combine these asset classes to create an investment strategy that aims to balance risk and reward by apportioning a portfolio’s assets according to your goals, risk tolerance and investment horizon.