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By Jude Fejokwu

Equity Investment — Classifying Your Financial Assets. Photo Credit: nirmaljain.wordpress.com

There are three main asset categories:

Cash and cash equivalents
Bonds (income investments)
Stocks (equity investments)

Each of these categories has risk associated with it. Generally, the more risk you assume, the higher the return should be. The relative risk pyramid below shows various investment choices ranked from highest risk and potential return at the top of the pyramid, to the lowest risk and potential return at its base.

Highest risk & expected return Lowest risk & expected return	Options, futures, low-priced or “penny” stocks
	Small-cap stocks, low quality stocks, collectibles, mid-cap stocks, low quality or “junk” bonds, specific industry/sector mutual funds
	Quality growth stocks or mutual funds, large cap stocks or mutual funds
	High quality convertible bonds or High quality convertible bond mutual funds, high quality preferred stock or high quality preferred stock mutual funds, balanced stock and bond mutual funds
	Money market accounts or money market mutual funds, high quality corporate bonds, high quality corporate bond mutual funds, high quality municipal bonds or high quality municipal bond mutual funds
	FGN bonds, Nigerian treasury issues, federal agency securities, insured savings and checking accounts, insured certificates of deposit

Cash and cash equivalents include Certificates of Deposit (CDs), savings and checking accounts and Treasury bills. These investments have low risk and thus low potential return. If too much of your portfolio is in these investments, the result likely will be that your money will not last through your entire retirement life-cycle. Bonds, also known as income investments, are classified in three different ways. First, every bond is given a grade. Standard and Poor’s grades bonds AAA through D. Those bonds with a grade of AAA through BBB are called investment grade. Bonds with grades BB through D are called high-yield or junk bonds. Second, bonds are classified by time to maturity. A short-term bond has a maturity of less than 5 years. Bonds with maturities between 5 and 10 years are considered mid-term. Long-term bonds are those with maturities of more than 10 years. Finally, bonds are classified into different categories. These categories include government, corporate, municipal and international bonds. A fixed-income instrument with a maturity period of a year or less is known as a Treasury bill. Some investors substitute high-dividend yield stocks for bonds in their portfolio. These are stocks that have dividend yields that are at least twice that of the large-cap average. Another way to tell if you have a high-dividend yield stocks, is to compare the stocks’ dividend yield to the current return on Treasury bonds. Short-term treasury bonds have returned 10% over the long-run, thus any stocks with a dividend yield in excess of 10% could be considered a high-dividend yield stock. Stocks are also known as equity investments. Like bonds, stocks are classified in four different ways. First, stocks are classified geographically. For Nigerian investors, foreign or international stocks refer to companies which are located outside Nigeria. Second, stocks are grouped by their market capitalization or market cap. A market cap is determined by: multiplying the number of shares outstanding for a company by the present market price. Third – growth, value and income are all types of stock categories. Growth stocks are those stocks whose performance is tied closely with earnings per share (EPS) and sales growth rates. Value stocks derive their returns from the purchase of stocks whose price earnings ratio (P/E) is lower than its historical average and/or that of its industry peers. Income stocks were described in the previous paragraph – stocks that pay significant dividends. Finally, stocks are categorized as either common or preferred stock. Preferred stocks pay set dividends regardless of the company’s performance and their share holders are placed in line ahead of common shareholders in the case of a company’s demise. The ideal number of stocks for proper diversification is between 10 and 20 carefully chosen stocks. When you have less than 10 stocks in your portfolio you assume too much risk. More than 20 stocks in your portfolio, will not allow each stock to have enough impact on your portfolio performance to make it worth your time to track and research it. In other words, no individual stock should be more than 10% or less than 5% of your portfolio. In addition to diversifying your portfolio by size, you should also diversify by industry to reduce risk. Ideally, your portfolio should contain between 5 and 10 industries with 1 to 2 companies from each industry. Less than 5 industries in your portfolio significantly increases your chance of a loss. On the other hand, keeping track of more than 10 industries is very laborious and statistically does not lower your risk. Other assets classes worthy of mention are REITs, Mutual Funds, ETFs, Commodities and Derivatives. The last two are not yet in play in Nigeria. When it comes to investments, variety is the spice of life!

Jude Fejokwu is the Principal Analyst at Thaddeus Investment & Research Ltd. He can be reached by email: thaddeusinvestments[at]gmail.com