When investing comes up, most people picture stocks. But stocks are only one of the so-called asset classes - the big families of investments that differ in how they earn, how much they fluctuate, and what role they play in a portfolio. Once you understand the three basic classes - stocks, bonds, and cash - and the vehicles that package them into a single product, you have the complete map. Everything else is just detail.
The three basic asset classes
Stocks are stakes in companies. They earn through the growing value of the business and possibly dividends - and of the three classes they earn the most over the long run, at the price of the biggest swings. Bonds are loans: you buy the debt of a government or a company and receive a predetermined interest rate. They earn less but behave more calmly. Cash and its equivalents - money in a savings account, term deposits, money market funds - earn the least, but they are instantly available and barely fluctuate at all.
None of these classes is better than the others. Each does a different job - and a good portfolio combines them according to when you will need the money and how much fluctuation you can bear. The article on risk and the investment horizon covers this in detail.
A fund: many investments in one wrapper
Buying dozens of stocks and bonds one by one is laborious and impractical for small amounts. That is why funds exist: professionally managed baskets into which investors pool their money, and the fund uses it to buy dozens to thousands of securities. You then own a share of the whole basket.
An ETF (exchange-traded fund) is a fund traded on an exchange - bought and sold as easily as a stock, at any time during trading hours. The vast majority of ETFs are index funds: they do not try to beat the market, but to faithfully track a stock index - a basket of companies assembled by clear rules. With a single purchase of such an ETF you hold hundreds of the world's largest companies at once - and with them a spread of risk that would take years to build through individual purchases.
Index ETFs, or individual stocks?
Here the paths of investors divide - and both are legitimate.
- Index ETFs offer simplicity and peace of mind. You do not have to pick companies, read earnings, or follow the news; you buy the whole market and rely on its long-term growth. The failure of a single company barely moves the result. The price of that convenience: you give up the chance to beat the market, and you also hold companies you would never have picked yourself.
- Individual stocks give you full control. You choose businesses you understand and believe in, and with good picks you can beat the index. The price of that control: you need to learn how to evaluate companies, put in the time, and live with the fact that the outcome rests on your decisions.
Many investors combine both paths: a broad index ETF as the foundation, plus a smaller part of the portfolio in selected stocks. If you want to learn to judge stocks, fair value assessment is a good starting point - which is exactly what the Fair Price Index is for.
Active funds and the TER fee
Alongside index funds there are actively managed funds: a portfolio manager picks the investments with the goal of beating the market. For this work the fund charges an ongoing annual fee, which you will find under the abbreviation TER (total expense ratio). For index ETFs the TER commonly sits in tenths of a percent or lower; for active funds it tends to be an order of magnitude higher - often one to two percent a year.
The difference looks tiny, but the fee is deducted every year from the entire value of your investment - and it compounds exactly like returns do, only against you. Over twenty years, the difference between 0.2% and 1.5% a year can bite off a noticeable share of the final value. On top of that, it is a widely known and repeatedly confirmed fact that most active funds fail to beat their benchmark index over the long run after fees. That does not mean a quality active fund cannot exist - it means the TER is a number you always look up before buying any fund.
Bonds: the anchor of a portfolio
A bond is a loan with clear rules: you know what interest you will receive and when the principal will be returned. Government bonds of developed countries rank among the safest investments there are; corporate bonds pay somewhat more in exchange for the higher risk that the borrower will not pay. Bonds, too, can be conveniently bought through ETFs, without having to pick individual issues.
In a portfolio, bonds play the role of a stabilizer. When stock markets fall, quality bonds usually fall far less, or hold their value. The shorter your horizon and the worse you handle swings, the larger the share of the portfolio bonds typically deserve. With individually held bonds there is one more advantage: held to maturity, the total return is known in advance - a certainty stocks never offer.
One warning about individual corporate bonds: promises of unusually high interest from small, unknown companies are among the most common ways beginners lose money. A high promised interest rate always reflects high risk - and with bonds this is doubly true.
Cash equivalents: money within reach
The last class is money itself and the instruments closest to it: savings accounts, term deposits, money market funds. Their job is not to earn - over the long run they usually cannot even keep up with inflation. Their job is to be instantly available: for the emergency fund, for expenses planned in the next few years, and for the peace of mind that keeps you from having to sell investments at the wrong moment.
And with that the map is complete: stocks for long-term growth, bonds for stability, cash for availability - and funds and ETFs as the practical wrapper that makes it all accessible even with small amounts. How to choose the account you will buy through, and what your first trade looks like, is covered in the article Broker and your first purchase.