Investing: an introduction

Understanding the Investment Risk Ladder

Here are the major asset classes, in ascending order of risk, on the investment risk ladder.

Cash

A cash bank deposit is the simplest, most easily understandable investment asset—and the safest. It not only gives investors precise knowledge of the interest that they’ll earn but also guarantees that they’ll get their capital back.

On the downside, the interest earned from cash socked away in a savings account seldom beats inflation. Certificates of deposit (CDs) are less liquid instruments, but they typically provide higher interest rates than those in savings accounts. However, the money put into a CD is locked up for a period of time (months to years), and there are potentially early withdrawal penalties involved.

Bonds

A bond is a debt instrument representing a loan made by an investor to a borrower. A typical bond will involve either a corporation or a government agency, where the borrower will issue a fixed interest rate to the lender in exchange for using their capital. Bonds are commonplace in organizations that use them to finance operations, purchases, or other projects.

Bond rates are essentially determined by interest rates. Due to this, they are heavily traded during periods of quantitative easing or when the Federal Reserve—or other central banks—raise interest rates.

Mutual Funds

A mutual fund is a type of investment where more than one investor pools their money together to purchase securities. Mutual funds are not necessarily passive, as they are managed by portfolio managers who allocate and distribute the pooled investment into stocks, bonds, and other securities.4 Most mutual funds have a minimum investment of between $500 and $5,000, and many do not have any minimum at all. Even a relatively small investment provides exposure to as many as 100 different stocks contained within a given fund’s portfolio.

Mutual funds are sometimes designed to mimic underlying indexes such as the S&P 500 or the Dow Jones Industrial Average. There are also many mutual funds that are actively managed, meaning that they are updated by portfolio managers who carefully track and adjust their allocations within the fund. However, these funds generally have greater costs—such as yearly management fees and front-end charges—that can cut into an investor’s returns.

Mutual funds are valued at the end of the trading day, and all buy and sell transactions are likewise executed after the market closes.

Exchange-Traded Funds (ETFs)

Exchange-traded funds (ETFs) have become quite popular since their introduction back in the mid-1990s. ETFs are similar to mutual funds, but they trade throughout the day, on a stock exchange. In this way, they mirror the buy-and-sell behavior of stocks. This also means that their value can change drastically during the course of a trading day.

ETFs can track an underlying index such as the S&P 500 or any other basket of stocks with which the ETF issuer wants to underline a specific ETF. This can include anything from emerging markets to commodities, individual business sectors such as biotechnology or agriculture, and more. Due to the ease of trading and broad coverage, ETFs are extremely popular with investors.

Stocks

Shares of stock let investors participate in a company’s success via increases in the stock’s price and through dividends. Shareholders have a claim on the company’s assets in the event of liquidation (that is, the company going bankrupt) but do not own the assets.

Holders of common stock enjoy voting rights at shareholders’ meetings. Holders of preferred stock don’t have voting rights but do receive preference over common shareholders in terms of the dividend payments.

Alternative Investments

There is a vast universe of alternative investments, including the following sectors:

• Real estate: Investors can acquire real estate by directly buying commercial or residential properties. Alternatively, they can purchase shares in real estate investment trusts (REITs). REITs act like mutual funds wherein a group of investors pool their money together to purchase properties. They trade like stocks on the same exchange.
• Hedge funds: Hedge funds may invest in a spectrum of assets designed to deliver beyond market returns, called “alpha.” However, performance is not guaranteed, and hedge funds can see incredible shifts in returns, sometimes underperforming the market by a significant margin. Typically only available to accredited investors, these vehicles often require high initial investments of $1 million or more. They also tend to impose net worth requirements. Hedge fund investments may tie up an investor’s money for substantial time periods.
• Private equity fund: Private equity funds are pooled investment vehicles similar to mutual and hedge funds. A private equity firm, known as the “adviser,” pools money invested in the fund by multiple investors and then makes investments on behalf of the fund. Private equity funds often take a controlling interest in an operating company and engage in active management of the company in an effort to bolster its value. Other private equity fund strategies include targeting fast-growing companies or startups. Like a hedge fund, private equity firms tend to focus on long-term investment opportunities of 10 years or more.
• Commodities: Commodities refer to tangible resources such as gold, silver, and crude oil, as well as agricultural products. There are multiple ways of accessing commodity investments. A commodity pool or “managed futures fund” is a private investment vehicle combining contributions from multiple investors to trade in the futures and commodities markets. A benefit of commodity pools is that an individual investor’s risk is limited to her financial contribution to the fund. Some specialized ETFs are also designed to focus on commodities.

Many veteran investors diversify their portfolios using the asset classes listed above, with the mix reflecting their risk tolerance. A good piece of advice to investors is to start with simple investments, then incrementally expand their portfolios. Specifically, mutual funds or ETFs are a good first step, before moving on to individual stocks, real estate, and other alternative investments.

However, most people are too busy to worry about monitoring their portfolios daily. Therefore, sticking with index funds that mirror the market is a viable solution. Steven Goldberg, a principal at the firm Tweddell Goldberg Wealth Management and longtime mutual funds columnist at Kiplinger.com, further argues that most individuals only need three index funds: one covering the U.S. equity market, another focused on international equities, and the third tracking a broad bond index.

More hands-on investors, however, may want to choose their own asset mix when crafting a diversified portfolio that fits their risk tolerance, time horizon, and financial goals. This means that you can try to capture excess returns by tilting your portfolio weights to favor certain asset classes depending on the economic environment.

Asset Class Expectations Given the Economic Environment

Let’s first consider the relative performance of stocks and bonds, which historically have shown somewhat of an inverse correlation:

• When the economy is strong and growing, with low unemployment, stocks tend to perform well as consumers spend and corporate profits rise. At the same time, bonds may underperform as interest rates rise to keep track with economic growth and inflation. When inflation is high, fixed-rate bonds may also fare comparatively worse if the coupon rate is below the rate of inflation.
• When the economy is turning sour and recession hits, unemployment rises and people stop spending as much, hurting corporate profits. This, in turn, can weigh down on stock prices. But, as interest rates fall in response to a sagging economy, bonds may outperform.

Most financial professionals recommend a portfolio mix consisting of stocks and bonds, as described above. Other asset classes, too, may favor certain economic conditions; however, not all asset classes are suitable for investors.

• Real estate: A strong economy and low unemployment can lead to a robust housing market, which may benefit real estate investments. However, rising interest rates can put a damper on mortgage borrowing.
• Commodities: Inflationary environments can lead to an increase in the prices of certain commodities, making them a favorable asset class to use as an inflation hedge.
• Alternative investments: Private equity, venture capital, hedge funds, and other non-traditional investments may outperform in an environment of low interest rates and high liquidity. These types of investments, though, are not always available to individual investors and may require a significant outlay of cash and feature lower levels of liquidity.
• Gold: Gold is considered as a safe haven asset and it performs well in times of economic uncertainty, geopolitical tensions and during inflationary environment. This was especially the case during the COVID19 pandemic, which saw gold rise to all-time highs during the Spring of 2020.
• Cash and cash equivalents, (e.g. money market funds and CDs): These also tend to perform relatively well in uncertain or volatile economic environments is because they, too, are considered to be a safe haven. Investors may turn to cash as a way to preserve their capital and limit downside exposure to risk during bear markets. However, in a stable and low-inflation environment, cash will not usually provide returns as high as other asset classes such as stocks or bonds – but the stability and the low risk make a small allocation to cash an attractive option for investors seeking preservation of capital or for short term liquidity needs.

What Are the Different Asset Classes?