What are the different asset classes, and how can I diversify them in my portfolio to reduce risks and maximise potential returns?
Asset classes group investments that are similar in terms of risk, return, liquidity, and market sensitivity. The main ones are stocks, bonds, currencies, real estate, and precious metals, each with its own advantages and disadvantages. Diversifying your portfolio by spreading investments across these classes is essential to reduce overall risk and optimise returns, tailored to the investor's goals and risk profile. We present the main asset classes and provide examples of secure diversification combinations.
Stocks
A stock represents ownership of a fraction of a company's capital, granting the investor rights such as the ability to vote on dividends and at general meetings, as well as to receive dividends based on the company's performance. Listed on the stock exchange, their prices fluctuate according to supply, demand, and the company's profitability prospects.
The liquidity of a stock refers to how easily it can be bought and sold on the market, determined by the volume of transactions and the presence of buyers and sellers. Liquidity is generally higher for stocks on major stock markets, such as the SMI in Switzerland, which in turn influences the stock’s price and return.
Return
The return on a stock consists of two elements:
- Dividend: This represents the portion of the company’s profits distributed to shareholders. It can be fixed or variable, but it is not guaranteed
- Capital gain: This is the difference between the selling price and the purchase price of the stock on the market
The return on a stock is unpredictable and uncertain. It can be very high if the company performs well and the market is favourable, but it can also be zero or negative if the company faces difficulties or the market is unfavourable.
Risk
The risk of a stock is the probability that the investor may lose all or part of their invested capital. It is linked to the stock's volatility, which refers to the extent of its price fluctuations on the market. This risk is also influenced by factors such as the quality of the company, its industry sector, financial situation, strategy, governance, and more.
Bonds
Bonds are debt securities issued by governments, public entities, or private companies. By purchasing a bond, the investor lends money to the issuer and, in return, receives interest payments and the repayment of the principal at maturity.
The liquidity of a bond refers to how easily it can be bought or sold on the secondary market. It depends on the size of the issuance, the frequency and volume of transactions, and the transparency of the market.
Return
This corresponds to the interest rate it offers, as well as any potential capital gain if sold, as bonds are traded on the market. The return depends on:
- The duration
- The credit risk
- The economic conditions
- The monetary policy set by the central bank
The higher the issuer's default risk, the higher the offered interest rate. The interest can be fixed or variable, depending on the type of bond.
Credit risk
This risk is associated with the likelihood that the issuer may fail to repay the principal or interest. The risk is measured by the credit rating assigned by specialised agencies (e.g., Standard & Poor’s and Moody’s). The higher the rating, the lower the risk.
Currencies
A currency is a monetary unit used in a country or economic area (for example, the euro, the dollar, the yen, etc.). The foreign exchange market, also known as Forex, is where currencies are quoted against each other in the form of exchange rates. The exchange rate expresses the value of one currency relative to another. Investors speculate on fluctuations in exchange rates.
The liquidity of a currency investment refers to how easily and quickly it can be bought or sold on the foreign exchange market, depending on the volume of transactions. The foreign exchange market is the most liquid in the world, with average daily trading exceeding USD 6.5 trillion.
Return
This depends on the fluctuation of the exchange rate between the currency held and the reference currency (usually the currency of the investor's country of residence). The return on a currency investment can also be influenced by inflation, the interest rate paid in the currency, or the balance of trade of the countries involved. Over time, the most stable currencies tend to attract more capital.
Risk
The risk of a currency investment is linked to the uncertainty surrounding future exchange rate movements, which can be influenced by numerous economic, monetary policy, or geopolitical factors. For example, a financial crisis, a war, or a central bank decision can trigger major fluctuations in exchange rates.
Real Estate
Real estate is one of the oldest and most popular asset classes. It refers to properties such as land, buildings, or housing, which can be bought, sold, or rented. Real estate investment can be made directly in one or more properties or indirectly through investment funds.
The liquidity of real estate is often limited by the time required to find a buyer or tenant, as well as by transaction costs. Therefore, it is generally lower than that of other financial assets.
Return
It corresponds to the income generated by real estate, in the form of rental income, capital gains, or dividends paid by a real estate fund. The return on real estate depends on the quality, location, and demand for the property, as well as market conditions.
Risk
The risk of real estate is associated with price volatility, rental vacancies, maintenance costs, interest rate conditions, particularly through mortgage rates, taxes, and regulations. Real estate risk is generally considered lower than that of equities but higher than that of bonds.
Precious metals
Precious metals are tangible assets with intrinsic value, prized for their rarity, beauty, and utility. The main precious metals include gold, silver, platinum, and palladium. They can be purchased in physical form (coins or bars) or in paper form (metal accounts or futures contracts).
Precious metals are liquid assets that can be easily traded on international markets.
Return
Precious metals tend to perform well over the long term, especially during times of economic or political crises or monetary shocks. They provide protection against inflation, currency devaluation, and loss of confidence in the financial system. However, these assets do not generate interest or dividends.
Risk
Precious metals are subject to market volatility and fluctuations in supply and demand. They can experience significant short-term corrections, influenced by geopolitical events, speculation, or central bank interventions.
How to diversify your portfolio to reduce risks and maximise returns ?
There are no universal rules for diversifying your portfolio, as it depends on your investor profile, investment horizon, risk tolerance, and financial goals. This is why it's important to seek guidance from a financial specialist.
However, there are some general principles to follow to build a diversified portfolio that can effectively withstand market fluctuations.
Allocate your capital across multiple asset classes
Once your objectives are clearly defined, diversify your investments based on their level of return and risk. For example, you might allocate 40% to equities and 60% to bonds if you are seeking a balance between performance and security. If you're aiming for higher returns and are willing to take on more market volatility, you could reverse this allocation.
In your strategy, focus on assets with low correlation to each other, meaning they don't respond in the same way to events. This diversification within the market adds even more robustness to your investment. To better protect yourself against stock market fluctuations or currency depreciation, you can add currencies or precious metals to your portfolio. However, keep in mind that a single position should not exceed 20% to 25% of your total account.
Opt for investment funds
How should you proceed if you want to invest in one of the five asset classes, but you’re unsure about which companies, bonds, currencies, properties, or metals to choose? In this case, purchasing shares in investment funds can be an excellent solution. A fund is essentially a "basket" that contains dozens, or even hundreds, of underlying securities. By buying a share in an equity fund, for example, you spread your risk across all the stocks within that fund.
Diversify according to market trends and your needs.
Last but not least, adjust your diversification based on market trends and your needs. For example, you might reduce your exposure to equities and increase your allocation to bonds as you approach retirement, to secure your capital and income.
There are several investment solutions available, and new products are constantly emerging on the market. This is why at Piguet Galland, we are here to help you develop the best investment strategy. Our advisors are at your disposal to offer you 100% personalised solutions at every stage of your life.
