Investing 101 Part 2: Where to Invest or Introduction to Asset Classes

In the first part, we discussed why one should invest, and mentioned the various investment asset classes that are available today for us to invest our money in.

In this part, we will go over all the asset classes one by one to understand each of them better, so that we know what to expect from which one.

Let us start with the simplest first.

1. Debt (Fixed Deposits and Bonds)

This is the simplest one. You loan money for a specific period of time and get interest on that. At the end of the loan period, you get your original principal back.

It is not entirely risk-free as there is the risk of default - what if you don't get your principal back at the end of the loan term?

But depending on who you are loaning money to, the risk can be negligible or substantial.

When you make an FD, you are loaning money to your bank. You can loan money to other people also e.g. to your friend (peer to peer lending), to a company (by buying corporate bonds), or even to the government (by buying government bonds).

Your friend will probably give you the highest interest rate as the risk of default is higher with your friend, and your bank will probably give you the lowest interest rate as there is almost zero risk of default.

What kind of returns can you expect from this asset class?

Safe and stable, but not high. A bank Fixed Deposit is the most popular example of a debt investment. The returns will generally just track inflation.

2. Equity (Stocks and Shares)

This is globally the biggest asset class. Yes, more of the world's wealth is held in stocks than in real estate or gold.

Investing in equities means buying shares in other people's businesses, thereby getting partial ownership of that business and its profits.

If the business does well, the profits are passed on to the shareholders in the form of higher share price and/or dividends. If the business does poorly, the share prices decrease, thereby losing investment value.

Shares of big companies can usually be purchased on stock exchanges, while you may need to approach the owners of small businesses individually in order to buy shares in their business.

Generally when people refer to investing in the stock market, they are referring to buying and selling the shares of the big companies listed on the country's stock exchanges, like BSE and NSE.

Even though there are businesses which do vastly different things, typically their fortunes move together. In good economic environments, most of them do well and so does the stock market, whereas in bad economic environments almost all of them go down together.

Why are equities the biggest asset class? Why do so many people invest so much money in equities? Because businesses have the greatest potential for returns.

Businesses create value for their consumers. A business may spend Rs 100 in making something using raw materials, land, labour and technology and the end product might be worth Rs 120 to its users - thereby creating a value of Rs 20. This value creation is only limited by our own creativity and ingenuity and generally ebbs and flows with economic progress of the world. For great businesses like Apple and Google, the sky is the limit, but even average businesses generally need to do better than inflation in order to survive.

What can you expect from equity investments?

  • Potential for higher returns in the long term - In India, the stock markets have generally given returns of 12-16% averaged annually over the long term in the past. How long is long term? Given that all of this is linked to businesses doing well, one must invest for at least one business cycle when investing in equities, which typically is 6-7 years or longer.

  • Potential for losses, especially in the short term - Stock markets can go up 20% or down 20% in any given year. During the economic crisis of 2008, the stock markets went down as much as 50-60% before recovering. These events, and in general stock market returns, cannot be predicted beforehand with any degree of certainty. If it was possible to predict a crash, the crash would never happen. However, even after all the crashes and negative years, stock markets have still delivered above-inflation returns to patient investors.

  • High volatility both in the short and long term i.e. there will be lots of ups and downs, and occasional big negative and positive years - even after you have been investing for 10 years. So investing for the long term, while necessary, will still not shield you from the daily ups and downs of the stock markets. You will just get used to it.

3. Real Estate

Another very popular investment asset class globally, and especially in India. Its appeal lies in its social significance (if you have your own house, you are considered settled), as well as the tangible nature of land and property.

"They are not making any more land," goes the investment thesis, but this overlooks the fact that currently less than 2% of land is being inhabited, even in India. With every passing year, more of that uninhabited land is coming under habitation - so they are making more land - in a manner of speaking. This is also evident in real estate prices that have become stagnant for some years now.

Real estate markets also undergo the same boom and bust cycles that equities undergo, but are more tempered - the upside is less (yes!) and so is the downside. Also, since there is no one announcing a price on TV for your home everyday, one does not feel the emotional highs and lows that come with investing in stocks.

Real estate investments are highly illiquid - they require big ticket investments, offer little diversification (you cannot spread your real estate investments if you are not a billionaire), require upkeep, are tax-inefficient, and if you need some money, it is not as if you can sell off one room of your 3BHK flat and make ends meet.

So overall in real estate, one can expect returns and volatility to be something in between that of debt and equity. But considering the illiquidity and the hassles that come with it, it does seem like this asset class gets more credit than is due.

4. Gold

This is another very popular investment asset in India. But for all its glitter, it is not an economic asset i.e. it does not have much economic use. Hence, its value is primarily derived not from what it can earn (as is the case with other asset classes) but from inflation and its perception as a safe asset during times of economic stress.

Typically, a more than 10% permanent allocation to Gold is not recommended by any investment advisor, as the long term returns are similar to inflation only.

So, to summarize:

  • Debt (eg Fixed Deposit) is the safest
  • Equities (Stocks) give the highest returns in the long term, but only if one can sit through the volatility that comes with it
  • Real Estate is somewhere between debt and equity, but too illiquid and hassle-prone
  • Gold has little value-add as an investment asset (except during economic crisis).

Real Returns Comparison: Stocks vs Real Estate vs Fixed Deposits

How does this all apply to you? Should you invest all your money in equities then? And so far we have not even discussed Mutual Funds. What are they - a separate asset class or just a tool?

Read more in Part 3.