Ok, we have covered the different asset classes, and we have understood that the basic minimum benchmark is inflation in our base currency. So how are these assets likely to behave over time relative to that benchmark? Well three of the asset classes are correlated to inflation and to each other, so although we can’t predict exactly, we have a pretty good idea what they will do over time in a particular base currency:
Take a look at the diagram above. It shows a rise in the cost of goods and services (inflation) over time. The first thing to note is that in the short term we really have no idea which asset will perform the best. We do know that cash will at least hold it’s value. Stocks, on the other hand, could rise or fall significantly. So, if you have a pile of money and are planning to do something important with it in the next 12 months, like make a down-payment on a house, you would be ill-advised to invest this money in the stock market. It might go down 30%! Therefore money for short term needs should stay in the bank.
Over the longer term, you won’t make money in cash. As you can see, cash tracks inflation to preserve your spending power, but it won’t increase it. If inflation is 2%, you might earn 2.5% in the bank. In Japan, where inflation is near zero, interest on a cash deposit is also very near zero. So if you want to make money over the long term, you have to take some risk.
One way you could take some more risk is by lending money to the government. The price of bonds may fluctuate over time, but in order to attract investment, bonds will pay a better return than cash. Note here that all bonds are not the same. A Japanese government bond may pay low interest, but there is little chance of default. A Venezuelan government bond may pay outstanding interest (10.43% p.a. on a 10 year issue at the time of writing), but there is a greater risk you won’t get your money back at the end of the term. Likewise corporate bonds carry higher risk than bonds issued by solid governments.
If you are looking for still higher returns, then it’s time to invest in the stock market. Although stocks are unpredictable in the short term, historically they outperform over a long period of time. This is because over time the economy and population tend to grow, and workers become more productive. This economic ground swell makes businesses more profitable, which drives up stock prices.
Although the other asset classes are uncorrelated and less easy to chart here, they can add valuable diversification. In building your own investment strategy there are a few things you need to take into account here:
The first is your base currency. The second is your time frame, which may vary from one investment objective to another. And the third is how you feel about the ups and downs in each of these asset classes, otherwise know as your attitude to risk. The better you understand the behaviour of different investments over time, the more you may find you are comfortable taking risk on a certain portion of your capital.
Striking the right balance between the different asset classes and maintaining that balance over time is know as Asset Allocation, a subject we will cover in future posts.