Introduction:
The ups and downs in financial markets have made many investors uneasy about investing in riskier assets. In such times, it often helps to take a step back and consider each asset class to better understand how it works and what to expect. The main types of asset classes are shares, property, bonds (or fixed interest), and cash. Within each asset class, there are further asset types. For example, within shares, investors can choose from Australian shares, international shares, or specific regions or countries like China or emerging markets.
Investors may sometimes base their investment decisions on the historical performance of asset classes, although this approach is fraught with danger. It is paramount that investors understand the different asset classes to ensure they make informed investment decisions. These different asset classes are explained below.
Australian Shares:
Shares represent part ownership in a company. There are different types of shares such as ordinary shares, preference shares, or partly-paid (contributing) shares. Owning shares in a company entitles the investor to participate in any dividends paid by the company from its profits, representing the income return from shares.
Dividends from Australian shares often include tax benefits in the form of franked dividends. Franked dividends are dividends paid by a company out of profits on which the company has already paid tax. The investor is entitled to a franking (imputation) credit, reducing the amount of income tax that must be paid, up to the amount of tax already paid by the company. This means that the investor avoids paying tax twice on the profits generated by the company – once by the company and again by the investor at their own tax rate.
Share ownership also exposes the investor to movements in the share price of the company. If the share price increases above the purchase price, the investor will make a capital gain. Conversely, if the share price falls below the purchase price, the investor makes a capital loss.
The price of shares can be influenced by several factors including the performance of the local and international economies, interest rates, inflation, the magnitude of competition in the industry the companies operate in, as well as investor sentiment.
Share prices tend to fluctuate substantially over short periods, but over longer periods such as five and ten years, their returns tend to be more reliable. For this reason, it is often suggested that investors consider share investments only if they are willing to stay invested for at least five years.
International Shares:
International shares are shares in companies domiciled outside Australia. Investors often spread their money across a range of countries and industries. Like Australian shares, the return from international shares is made up of any dividends received as well as the capital gain or loss resulting from the change in the company’s share price.
Key differences between international and Australian shares include:
- Dividends paid by international shares tend to be lower than those paid by Australian companies, resulting in a lower income return.
- International shares do not have franking credits and may not be as tax-effective as dividends paid from Australian companies.
- International shares offer a broader range of investment options, including access to different economic prospects and industries not well represented in Australia.
- Returns from international assets, including shares, are affected by changes in the Australian dollar. A stronger Australian dollar reduces returns when converted back to Australian dollars, while a weaker Australian dollar increases returns due to currency gains.
Property:
There are different types of property investments. An investor can purchase a property directly and benefit from rent received as well as changes in property valuation over time. The returns of these properties depend on tenant quality, rent paid, location, and type of property (residential, industrial, commercial).
Investors can also purchase properties via units in a trust (unlisted property trusts) or via a property trust listed on the Stock Exchange (listed REITs). Both unlisted and listed property trusts can borrow money, affecting returns and adding risk, especially if property valuations fall or income is insufficient to cover interest.
Bonds (Fixed Interest):
A bond is a tradeable debt security, usually issued by a government, semi-government, or corporate body to raise money. Investors in the bond lend money for a fixed rate of interest over a set period. The bond is repaid with interest on the predetermined maturity date. Some bonds can be traded on the share market.
Returns from bonds are based on the fixed rate of interest paid over the term. If the bond is traded, its price is affected by changes in market interest rates. If rates rise, bond prices fall, resulting in a capital loss. If rates fall, bond prices increase, resulting in a capital gain.
Cash:
Cash is one of the safest investments, including cash in the bank, cash management trusts, and even cash in your pocket. Cash returns are based on the official cash or interest rate set by the Reserve Bank of Australia as part of its monetary policy. The Reserve Bank changes the official interest rate to control inflation.
Putting It All Together:
The right investment depends on the individual investor and their needs and circumstances. Investors should consider their investment time horizon, the level of returns sought, and the amount of risk they are willing to accept. Combining asset classes in a portfolio to achieve diversification is wise, as it reduces risk by not putting all eggs in one basket. It should be remembered that past returns are not a good indicator of future returns, so investment decisions should not be based on historical performance.
The information contained in this article is general information only. It is not intended to be a recommendation, offer, advice or invitation to purchase, sell or otherwise deal in securities or other investments. Before making any decision in respect to a financial product, you should seek advice from an appropriately qualified professional. We believe that the information contained in this document is accurate. However, we are not specifically licensed to provide tax or legal advice and any information that may relate to you should be confirmed with your tax or legal adviser.
