No Nonsense Guide To Finance #1

Life is really simple, but we insist on making it complicated.

And as I am sure you’ll agree, the world of finance certainly does its fair share of adding to the complexity!

So, I always like to break down the terminology used by finance bods into language that actually means something to the rest of us.

In this post, we’re looking at building a portfolio and some of the terms that probably sound familiar, but may not be absolutely clear in your own mind.

What is an Asset Class?

When people talk about an asset class, they mean a group of investments that behave in a similar way in different market conditions. There 3 main asset classes:

  • Equities, or stocks/shares
  • Fixed Interest, or bonds
  • Money market instruments or cash

And some additional ones that are often added to the mix:

  • Commodities, e.g. gold, oil, coffee, wheat, etc.
  • Real estate
  • Alternative – examples include hedge funds, venture capital projects, antiques, fine wines, art.
  • Cryptocurrency? There is still a debate over where these fit in and if they could be a whole new class of their own

Having identified the asset classes you are dealing with, you’re now in a position to use an asset allocation strategy (see below) that reflects your tolerance to risk and your investment goals. 

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What is Asset Allocation?

Asset allocation is simply determining what the mix of investments will look like and how you ‘slice up the pie’.

What the mix looks like will depend on your risk attitude, tolerance and capacity (more on this another time), but also things such as your age and when you might want the money back.

For example, if you’re more conservative, close to retirement and you are looking to protect your money rather than push hard for growth, then (on a simplified level) the mix might be something like 50% in bonds, 10-20% in the money market and 30% in equities.

Conservative portfolios have a bigger slice of bonds and cash, since these assets are less volatile than equities.

If you are at the more aggressive end of the risk scale, you will have a higher amount allocated to equities and just a thin slice in bonds, as this mix will offer better opportunity for growth, but with a greater risk of loss.

A simple example of asset allocation

Unfortunately, in investing there is always a correlation between risk and return, so always be wary of anyone offering high returns with no risk.

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What is Diversification?

Investors often use diversification interchangeably with asset allocation, but they aren’t the same thing.

Asset allocation is about the mix of asset classes you use (e.g. 60% Equities, 20% Bonds, 10% Property, 10% Cash), whereas diversification is what you actually invest in within these classes.

Some eggs. One basket.

So, if you have 60% of your portfolio allocated to equities, the actual funds you invest in within this asset class is where diversification comes into play. When you think about diversification, just consider the saying ‘Don’t put all of your eggs in one basket’.

Using that 60% allocation to invest in a single technology fund is putting all of your eggs in one basket.

To be diversified, you need to consider the mix of sectors, regions, the market capitalisation (see below) and type of companies the fund invests in, etc.

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What is Market Capitalisation?

Market capitalisation is a figure used by finance bods as a simple measure to reference a company’s size. It is basically the total value of a company’s shares on the open market and is calculated by multiplying the amount of stock on the open market by the current price of the stock.

E.g. if EFG Ltd is trading at £10 per share and has 1 million shares on the market, the market capitialisation of EFG is £10 x 1,000,000 shares = £10,000,000.

That’s AWSOME! But so what? Why is it important?

Well, determining a company’s market cap allows us to classify them according to size and this in turn helps investors to make a call on growth potential and risk.

Historically, large cap companies are more stable, so less risky and provide slow, steady growth, while a small cap company may have higher growth potential, but can be a more risky proposition.

There is no fixed measurement for each category, but the general ranges are as follows:

  • Mega Cap = $300 billion and up (e.g. Facebook, Exxon, Apple, Amazon, Alibaba)
  • Large cap = $10 billion to $200 billion (E.g. McDonalds, Pfizer, Coca Cola, Walt Disney)
  • Mid Cap = $2 billion to $10 billion
  • Small Cap = $300 million to $2 billion

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Remember, just because you’re using an adviser or discretionary manager to look after your investments, it’s not an excuse to not understand what is going on.

Sure, you’re paying someone to do a job because you don’t have the time, inclination or knowledge to do it yourself, but knowing what asset class, asset allocation, diversification and market capitalisation all mean is the first step to having a better grasp and will go some way towards making discussions with your adviser much more productive.

 

Related content: No Nonsense Guide To Finance #2

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