Today, we shall explore the world of asset classes.
Asset classes are the types of assets we invest in. It has been shown that almost 95% of your investment return is determined by the proportion of money you have in a particular asset class.
Hence it is not that important to choose a particular stock for you to be successful in investing.
However you need to make a decision based on your circumstances as to how of much money you will put in a particular asset class. That will decide what sort of return you will get in the long run if you stay put.
The three basic asset classes are:
1. Stocks( your share of a business)
2. Bonds( your loan to a business)
Stocks: Owning a stock means you own part of a business. If a company grows and becomes more and more profitable, then the price of the business grows as well and you make a tidy profit.
If you own a single business that does well you do well. But if the business flops, you lose all your money. That is the disadvantage of owning individual stocks unless you know how to evaluate a business. A easier way is to invest in low-cost index funds that own the total stock market or buy groups of stocks. This decreases the chance you will lose money.
Bonds: You loan money to a company. It pays you interest at a regular interval and at the end of the loan period repays the principal back to you. If the company defaults on its payment you lose money.
Cash: You put money in a bank in a fixed deposit. It pays you interest regularly and your principal is safe.
When we look at financial history we find that stocks give the best return over a long period(30 years or more), then bonds and the last is cash.
So if you are young, invest a lot in stocks. As you grow older you put more of your money in bonds if you do not want to take the risk. If you invest 100% of your money in stocks you can lose up to 50% of your money in any one year.
A simple rule of thumb that people follow is: % of portfolio in stocks=100-age. So if you are 30 years old you have 70% in stocks and 30% in bonds. But you have to take your own personal circumstance into account and see how much you are willing to lose for a potential higher return and adjust this percentage accordingly.
Yes, there are other asset classes like property, gold, commodities, etc. But for most of us these three are enough: stocks, bonds and cash.