What types of asset should you invest in?

Monday, 17 September 2018

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Independent investment advice, Harris IFA, Boston Spa Yorkshire

Your overall asset allocation needs to reflect your future capital or income needs, the timescales before those capital sums are required or the level of income sought, and the amount of risk you can tolerate. Investing is all about risk and return. Most rational investors would prefer to maximise their returns, but every investor has their own individual attitude towards risk.

Investment characteristics

Determining what portion of your portfolio should be invested into each asset class is called ‘asset allocation’ and is the process of dividing your investment/s between different assets. Your overall asset allocation needs to reflect your future capital or income needs, the timescales before those capital sums are required or the level of income sought, and the amount of risk you can tolerate.

Portfolios can incorporate a wide range of different assets, all of which have their own characteristics, like cash, bonds, equities (shares in companies) and property. The idea behind allocating your money between different assets is to spread risk through diversification and to understand these characteristics and their implications on how a portfolio will perform in different conditions – the idea of not putting all your eggs in one basket. Not only does asset allocation naturally spread risk, but it can also help you to boost your returns while maintaining, or even lowering, the level of risk of your portfolio.

Looking into the future

Investments can go down as well as up, and these ups and downs can depend on the assets you’re invested in and how the markets are performing. It’s a natural part of investing. If we could look into the future, there would be no need to diversify our investments. We could merely choose a date when we needed our money back, then select the investment that would provide the highest return to that date. Moreover, the potential returns available from different kinds of investment, and the risks involved, change over time as a result of economic, political and regulatory developments, as well as a host of other factors. Diversification helps to address this uncertainty by combining a number of different investments.

Asset classes

When putting together a portfolio, there are a number of asset classes, or types of investments, that can be combined in different ways. The starting point is cash – and the aim of employing the other asset classes is to achieve a better return than could be achieved by leaving all of the investment on deposit.

Cash

The most common types of cash investments are bank and building society savings accounts and money market funds (investment vehicles which invest in securities such as short-term bonds to enable institutions and larger personal investors to invest cash for the short term). Money held in the bank is arguably more secure than any of the other asset classes, but it is also likely to provide the poorest return over the long term. Indeed, with inflation currently above the level of interest provided by many accounts, the real value of cash held on deposit is falling, even before we take into account the tax you may pay on the interest, and the effect of charges on cash held within a pension, ISA or investment portfolio.

Bonds

Bonds are effectively IOUs issued by governments or companies. In return for your initial investment, the issuer pays a pre-agreed regular return (the ‘coupon’) for a fixed term, at the end of which it agrees to return your initial investment. Depending on the financial strength of the issuer, bonds can be very low or relatively high risk, and the level of interest paid varies accordingly, with higher-risk issuers needing to offer more attractive coupons to attract investment. As long as the issuer is still solvent at the time the bond matures, investors get back the initial value of the bond. However, during the life of the bond, its price will fluctuate to take account of a number of factors, including:

  • Interest rates – as cash is an alternative lower-risk investment, the value of government bonds is particularly affected by changes in interest rates. Rising base rates will tend to lead to lower government bond prices, and vice versa
  • Inflation expectations – the coupons paid by the majority of bonds do not change over time. Therefore, high inflation reduces the real value of future coupon payments, making bonds less attractive and driving their prices lower
  • Credit quality – the ability of the issuer to pay regular coupons and redeem the bonds at maturity is a key consideration for bond investors. Higher-risk bonds such as corporate bonds are susceptible to changes in the perceived credit worthiness of the issuer

Equities

Equities, or shares in companies, are regarded as riskier investments than bonds, but theyalso tend to produce superior returns over the long term. They are riskier because, in the event of a company getting into financial difficulty, bond holders rank ahead of equity holders when the remaining cash is distributed. However, their superior long-term returns come from the fact that, unlike a bond which matures at the same price at which it was issued, share prices can rise dramatically as a company grows.

Returns from equities are made up of changes in the share price and, in some cases, dividends paid by the company to its investors. Share prices fluctuate constantly as a result of factors such as:

  • Company profits – by buying shares, you are effectively investing in the future profitability of a company, so the operating outlook for the business is of paramount importance. Higher profits are likely to lead to a higher share price and/or increased dividends, whereas sustained losses could place the dividend or even the long-term viability of the business in jeopardy
  • Economic background – companies perform best in an environment of healthy economic growth, modest inflation and low interest rates. A poor outlook for growth could suggest waning demand for the company’s products or services. Rising interest rates could put strain on companies that have borrowed heavily to grow the business
  • Investor sentiment – as higher-risk assets, equities are susceptible to changes in investor sentiment. Deterioration in risk appetite normally sees share prices fall, while a turn to positive sentiment can see equity markets rise sharply

Property

In investment terms, property normally means commercial real estate – offices, warehouses, retail units and the like. Unlike the assets we have mentioned so far, properties are unique – only one fund can own a particular office building or shop.

One major difference between property and equities/bonds is that a property cannot be bought or sold quickly or cheaply. This can make investing in property, or property funds, an unsettling experience, as you may not be able to get your money back when you want it. Some property funds prevented investors from exiting in the months after the EU referendum, for example.

However, the more normal state of affairs is for property to deliver a fairly steady rental income, and, over time, an increase in the capital value of the building. This can make property a valuable part of an investment portfolio, although we generally avoid having more than 15% of a clients' assets in property due to the liquidity issues mentioned above.

Diversification

Our job as independent financial advisers is to design an investment portfolio, combining the assets discussed above, as well as some others, in the right mix for your "appetite for risk" and your financial circumstances.

A high risk portfolio may deliver the highest returns over time, but not if the investor loses so much money during a market crash that they panic and take their money out of equities at the bottom of the market. As such, they key is to not just consider potential growth, but also to estimate the potential losses that a portfolio might experience during a downturn, and ensure that the client understands what might happen in future. That way, if we do get a period of poor market performance, the client is at least partly prepared for it and will be able to remain invested, knowing that their portfolio will recover in time.

Get in touch for more details of our portfolio management service, and to find out what kind of asset allocation we would recommend for you.

Chartered Financial Planners. FCA Regulated (FCA no. 603653). Free initial assesment.