Asset Classes, Markets and the Economic Environment
The four building blocks
Cash offers certainty and liquidity but loses purchasing power to inflation. Fixed income delivers coupon plus capital gain or loss, driven by credit risk and interest-rate risk. Equities deliver dividends plus capital growth and carry the residual claim on a company. Property and alternatives (commodities, infrastructure, private assets) add income and diversification but bring illiquidity and valuation lag. Each asset class is priced off expected cash flows discounted at a required return.
Markets and the economy
Know the difference between primary markets (issuers raise capital) and secondary markets (investors trade existing securities), and between exchange-traded and over-the-counter dealing, with the resulting differences in transparency and liquidity. The economic cycle - expansion, peak, contraction, trough - drives earnings, inflation and policy. Monetary policy (central-bank policy rates, quantitative easing) targets inflation and demand; fiscal policy (government spending and taxation) is set by the government. Currency moves reflect relative interest rates, inflation and trade balances.
Traps
- Bond prices and yields move inversely; the size of the move depends on duration and convexity.
- Nominal versus real returns: real return is approximately nominal minus inflation (Fisher effect).
- Rising inflation hurts long-duration nominal bonds and long-duration growth equities most.
- Confusing monetary with fiscal policy is a standard distractor.
- Correlations tend to rise in a crisis, just when diversification is needed.
Rule of thumb
Approximate bond price change = -duration x change in yield. A bond fund with duration 5 loses about 5% if yields rise by 1 percentage point, and gains about 5% if yields fall by the same amount.