So now you have an idea of your risk profile (tolerance) and you understand the relationship between risk and return, it’s time to look at characteristics of the broad asset classes or types of investment. It is important to understand the different investment types as each category has different levels of expected risk and return. Understanding what to expect from the different asset types will help you decide which categories of investments best suit your investment goals and your timeframe.
Generally speaking, there are considered five broad investment types or asset classes:
- Cash – investments like savings accounts, high interest accounts, bank bills
- Fixed Interest – includes government bonds and bond like securities issued by companies called hybrids
- Property – includes residential, retail, industrial and office properties.
- Australian Shares – are shares listed on the Australian Stock Exchange which cover many different sectors such as mining, healthcare, banking and retail.
- International Shares – are shares listed on exchanges outside of Australia including places like the United States, Europe or Asia.
I have listed the asset classes in order of risk. Generally speaking, cash is considered the least risky investment type and international shares are considered the most risky.
Given the Reserve Bank of Australia (RBA) cut rates again this week it is appropriate we kick off our look at the different investment types with a look at what is considered the safest but lowest return option, cash.
Cash generally refers to investments in high interest bank accounts, term deposits, bank bills and other securities which have a relatively short investment time frame. An investment in cash provides a stable, predictable income, in the form of regular interest payments. This category is all about income, with very little risk.
You might have heard the saying “cash is king”? This saying is usually used when the share market is very volatile. During these periods, such as the global financial crisis (GFC), investors move into cash for its safety and security. The problem with cash right now is that interest rates in Australia are at their lowest level since 1960, this means the returns on cash are at very low levels. However, if safety and security are your top priority or your investment time frame is short, then you can’t go past cash as an investment option.
Inflation is the other issue you need to be wary of when investing in cash, especially when interest rates are low. Anyone who goes shopping knows that, generally speaking, the price of things goes up every year. This is called inflation. It means that a dollar today will buy less goods and services in one years’ time as prices have increased. At the moment inflation is around 2.5%. So if you invest in an online account with an interest rate of 3.5%, then your post inflation return is only 1% (the difference between the interest rate earned and the inflation rate). If inflation is high and interest rates low, then it is possible to make a negative return after accounting for inflation. For example if inflation is 5%, but the interest rate earned on your account is only 2%, then you will earn a negative return of 3% after accounting for inflation. This is because the increase in the general level of prices, inflation, is greater than the increase in value of your investment through the interest earned. This is why it pays to shop around for the best cash rate possible and look out for any bonus interest deals. One of the best ways to do this is to use a comparison site. Two of my favourites are:
They both can give you comparisons on rates for online savings accounts and term deposits, including any bonus rates. Don’t be afraid to take the best bonus rate then move your money after the bonus period has finished. But remember, like with all investments read the full terms first before making any investment.
Next week we will look at the characteristics of fixed interest investments.
If you liked this post check out the rest of the series by clicking on the links below:
* Please note this is for your general information only and does not constitute financial advice.