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Which Asset Class To Invest In?

October 27, 2020
10 min
Which Asset Class To Invest In?
Beginner
You will learn

    The cryptocurrency market is decorrelated from traditional markets, such as stocks and bonds. This means that variations in cryptocurrency yields are not related to those of other traditional assets. However, comparing them allows us to highlight how cryptocurrencies react to the same risk-return parameters and can diversify your portfolio.

    Memo

    The cryptocurrency market is decorrelated from other markets as it does not depend directly on their performance. However, this does not make it immune to external factors that can affect investor behaviour and thus the market. Covid-19, for example, has led to a general collapse in cryptocurrency prices.

    The Financial Markets

    The financial markets are organized on the basis of public rules or practices. Here you can buy or sell financial instruments (shares, bonds, derivatives, mutual fund shares, etc.). The combination between supply and demand of financial assets is facilitated by the concentration of trading in the same “space” and at the same time.

    Investment strategies must be defined on the basis of all kinds of data concerning the financial markets. These pieces of information can be prices, macro and microeconomic analysis, as well as political and social factors.

    That’s why reading and keeping up to date is key. Finding out information before others can help us to play ahead and make better profits.

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    The 5 Financial Markets

    When you invest in a financial instrument, such as a stock or foreign currency, you participate in one of these markets:

    • bond market: bonds, government bonds, BTPs, etc.
    • stock market: equities, options
    • money market: BOTs
    • Forex market: foreign currencies
    • commodities market: futures, gold, oil, silver, etc.

    Any financial entity, whether a broker, fund or small investor, when investing money, necessarily puts them into one of these five markets. Even our bank reinvests the money we leave in our bank account, by purchasing a portfolio of financial instruments. So the investments we sign up for with the help of our bank or an intermediary are nothing more than sets of these instruments.

    The 4 Market Principles

    There are four principles we must bear in mind when deciding to invest in the financial markets:

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    The Market is Made Up of People

    First of all, a market is made up of people. Investors, company managers, brokers, traders, financial advisors, funds. These are all people who interact with the same instruments. Therefore, human behaviour and psychology have a huge impact, often in an unpredictable way. Especially in times of great uncertainty, the market responds with a domino effect that cannot be predicted.

    The market reflects life

    Unlike what we are used to thinking, the market is not an exact science. We look at our life as a gradual path of growth. In reality, this never happens. We take refuge in the tranquillity of a steady job, but it only takes a global crisis to lose it overnight. We buy a house, but sudden family needs force us to sell it and change cities. The truth is that markets, just like our lives, are one step away from shocks and swings.

    This is why we must:

    1. Never invest all our liquidity, but rather 20% max. of our savings (which is our earnings minus expenses).
    2. Deal with investments in an objective and realistic outlook.

    The market works on the long term

    One of the most frequent errors among investors (90%-95% of them) is to liquidate their assets in a time of crisis. In doing so, a virtual loss becomes a real loss and they leave the market at the worst time. But the market is a phoenix. It collapses and rises again and again. The winning strategy is to take a long-term view so as not to panic in moments of depression.

    The Main Asset Classes

    Asset classes are sets of homogeneous financial instruments, i.e. instruments that behave in the same way in the market and have similar characteristics.

    Memo

    There are no good or bad asset classes. Depending on personal goals, the investor will choose the most suitable one.

    Each instrument represents different characteristics of cost, liquidity, risk and of course return. Here is a list of the main ones: government bonds, bonds and stocks.

    What Are Government Bonds?

    The Ministry of Economy and Finance, on behalf of the Government, with the aim of financing the public debt, periodically issues a type of bond called Government bond.

    Risk and return

    Risk and return depend on the issuer, but they tend to be very secure assets because the failure of a State is unlikely. A bond issued by the State of Argentine, an emerging country with high economic instability, has higher risks and returns than, for example, a German bond.

    However, today, where interbank interest rates set by central banks are at zero (or even below zero), the difference between the interest paid by more secure bonds and interest paid by less secure bonds is subtle.

    Government bonds remain the class with the lowest volatility, that’s why interest rates are not very high. For example, investing €100,000 today in Italian government bonds with maturity in 2030 provides an annual interest rate of around 1.39%.

    How do you earn with government bonds?

    A government bond, like any bond, has a maturity date. At the end of the period, it guarantees the investor the repayment of the capital plus a fixed interest.

    Did You Know?

    Bonds are debt securities (for the entity that issues them, such as states, banks or companies) and credit securities (for the entity that buys them, the investor). Bonds are issued for the purpose of raising capital to be reinvested directly among savers, because they offer more advantageous conditions than bank loans.

    What Are Bonds?

    These are debt securities issued by banks, private companies or public bodies with the aim of raising liquidity. Whoever buys a bond pays money to the issuer who agrees to return it at maturity and pay an interest rate. The subscriber then becomes a creditor of the issuer. Also in this case the risk depends on the issuer.

    They allow calculating both the interest flow and the yield at maturity. It’s not a matter of forecasts, but of calculating the return on investment in advance and in a reliable way. In this way, investment decisions are always reasoned and based on objective data.

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    How do you earn with bonds?

    They are a kind of loan you make to a private company, public body or bank. The loan you grant entitles you to an interest rate called coupon. The interest rate is higher than that of government bonds because it is more plausible that the issuer will not be able to repay its debt to you.

    If the bonds are “zero-coupon”, the interest is not paid regularly (on a quarterly basis for example) but all at once when the bond matures.

    Differences with stocks

    If the issuer defaults (fails to repay the debt), an investor is better protected than shareholders. In fact, stocks do not provide compensation for losses, as they are not loans. Also, bonds tend to be (at least in part) the first to be repaid in the event of default.

    The interest rate is higher for companies that have a higher risk of default: riskier bonds yield more than less risky ones. This is because the higher the risk of default, the higher the amount that the debtor has to pay to persuade the creditor to lend their money.

    Did You Know?

    The spread is the difference in yield between two bonds or stocks of the same type and of the same duration, where one of the two is the benchmark for security. For example, to calculate the spread on Eurozone government bonds, we tend to take German bonds as a reference for the strength of their economy.

    What Are Stocks?

    These are the most common and popular financial instruments. Stocks represent company shares or equity. This means that, by purchasing a stock, the investor becomes a co-owner of the company by participating fully in its economic risk.

    The value of our stock will rise or fall according to the company’s operations and the growth potential of the market in which it operates. The popularity of the company also affects stock prices. The more people request the stocks (i.e. demand grows), the more their value increase.

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    How do you earn with stocks?

    Stocks allow you to earn money in two different ways: with the value of the stocks and with dividends. Dividends are payments that companies make to their shareholders as a distribution of annual profits (generally on a quarterly basis). However, the company may decide to allocate those dividends to new investments to expand its business. This is typical of high growth companies, such as Google and Facebook.

    Instead, companies with larger earning but fewer opportunities for expansion, tend to pay high dividends regularly (e.g. a freeway company).
    In addition, if you sell the stocks and if since you purchased them their price has risen, you will have a higher gain.

    Risk

    Stocks carry a greater risk because the company can close an unprofitable year or even fail. In addition, factors inside and outside the company can lead investors to disinvest, determining an increase in supply and a consequent lowering of the stock price.

    Memo

    High growth companies often do not guarantee dividends because they usually are reinvested to expand the business, thus increasing their stocks value over time. Companies with high dividends, over the long term can become a constant source of income. At the same time, the value of their stock will not increase significantly.

    In the next article we will analyse the other financial instruments and how to identify the most suitable ones for us.

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