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The term “asset class” describes a set of investment options that are grouped into a similar area or type. The main asset classes are cash, fixed interest, property and shares. There is also a group of investment products that have tended to be labelled “alternative” as they don’t readily fit into the parameters of the other asset classes.
The reason why it can be helpful to have an understanding of the different asset classes is that each has different levels of risk and return. Knowing what to expect can help you decide the type of investments that will suit your circumstances. You will also be able to judge your investments based on whether you prefer growth or income assets. The other thing people tend to overlook is how the different classes will be taxed, which is surprising because the after tax cash flow is perhaps a better measure for the return an investor can expect to earn.
Every investment carries an element of risk, and the main reason that people need to be confronted with risk is that it generally becomes inextricably linked to the level of return on any investment.
The trade-off between risk and return is well established – generally, the higher the risk an investor is able or willing to take, the higher the potential rewards (or return). Put another way, if a particular investment offers huge returns, this can be an indication that it will come with equally huge risks.
Conventional wisdom holds that reducing risk can be achieved through diversifying what you invest in. But where you invest will also be influenced by how long you are prepared to have your money tied up, your own view of that risk/reward trade-off, and your financial objectives.
Of the asset classes, cash and fixed interest both tend to be favored by investors who are more risk averse, and who are willing to trade some potential earning power for increased security and more consistency of returns. Investment in the asset classes of property and shares have more scope to grow the capital base of your investments, but in doing so tend to be more variable in performance while offering greater potential returns.
Cash investments include bank deposits, bank bills and short-term government bonds. There is generally no capital growth, but regular interest payments and more stable, low-risk income. When official interest rates change, cash investment rates should move in the same direction. Your investment base (the original sum of money you invested) is also generally available at short notice. Investors should however keep in mind that the lower rate of return will need to be above the inflation rate, otherwise the investment overall goes backwards. The interest income earned on these deposits is generally added to the assessable income of an investor when it is derived as ordinary income (received by the investor). This interest income is then taxed at the investor’s tax rate.
The slightly higher interest rates for such investments, which include bonds and term deposits, are due to the longer term nature of them. A bond, for example, can be viewed as a “loan” to an entity (corporate or government) that uses the money invested (for a defined period and for a fixed rate of return) to fund various projects and activities over months or even up to many years.
Fixed interest products can still be converted to cash very quickly, but the investor may forfeit some return for doing so. Unlike cash investments, official interest rate changes can have an inverse impact on the value of these investments. A rising rate for example will see bond prices move in the opposite direction (an investment offering 4% will be worth less once an alternative promising 4.5% becomes available). Also there will be no capital growth over the life of the investment. Much like cash, these type of investments are generally added to assessable income when received and subject to an investor’s tax rate.
This is not limited to tangible real estate such as houses or commercial buildings, but can include property trusts, which basically pool invested money together to buy into larger property assets. As a property can increase in value over the life of an investment, there is the real potential for capital growth. But equally there is no guarantee, and still the possibility that the value of properties can head south. As well, income returns may not be as predictable as cash or fixed interest, and will depend on aspects such as rental return, occupancy levels and the wider market conditions.
The rental return on these investments is generally added to assessable income much like cash and fixed interest investments. The expenses relating to the financing, maintenance and repair as well as occupancy of the property will generally be deductible and offset against the rental income to reduce it (and in some cases negate it completely, or even be deducted against other forms of income where deductible expenses exceed rental income).
The capital growth is generally subject to the CGT rules before it is added to income to be taxed. This means that generally for properties held over greater than 12 months, only 50% of the gain may be added to assessable income and taxed. Furthermore, certain costs of acquisition and disposal are taken into account to calculate a capital gain. The taxation of distributions from a trust can be complex and is best left to a qualified tax agent.
The fluctuation in the value of shares highlights the more volatile nature of this form of investment. Shares are easily traded, which makes them flexible, and this has also contributed to the historically higher returns that the sharemarket can offer – astute buying and selling can make (or break) the sharemarket investor.
International shares can offer even higher returns over time, but local shares can give additional tax benefits with regards to CGT and the dividend imputation system in affect in Australia. Investment in local shares is also free of currency fluctuation considerations.
Shares also potentially provide both income, through dividend payments, as well as capital growth (or loss) through changes in the value of the shares themselves. There is the potential to lose a great part of the initial money invested, but an equal potential to increase that underlying value several times. The share price itself will fluctuate depending on the conditions of the general economy as well as the performance of the particular company and the sector or industry it operates in.
Dividends that are unfranked are generally added to assessable income and taxed at an investor’s tax rate. Franked dividends (which must come from a company that earns profit within Australia) are also added to assessable income (as are imputation credits attaching to them). However, an offset is generally available to investors equal to the franking credit received by the investor, which will reduce the tax payable for the investor. Depending upon whether an investor is in the business of share trading or simply investing passively, the capital gains tax rules may also apply to capital gains and losses on shares.
There is really a fifth class of investment, but because of their nature these require a much deeper familiarity with financial tools and mechanisms. The alternative asset class includes investment in hedge funds, infrastructure bonds, fund-of-funds, commodities and futures, and derivative investments like contracts-for-difference and put and call options.
As these are very complex products that even challenge many hard-core Wall Street investors, they need to be approached with cautious enthusiasm. However used judiciously, and again because of their make-up, these alternative investments can also offer a diversification that will tend to produce lower returns in boom markets while having the potential for higher returns in down markets. As such, this is a diversification that of its nature can further even out the overall risk built in to your portfolio – which long-term can mean a smoother ride.
Alternative investments will more likely find a place in the portfolios of larger institutions or the big superannuation funds. The tax implications for these sort of investments can vary widely.
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