Cash is conventionally regarded as a risk-free asset class, provided the eroding effect of inflation is not taken into account. A fall in the stock market or in property prices should not lead to a fall in cash values. It would always be considered prudent to keep an adequate cash reserve for unforeseen eventualities – the proverbial rainy day.
We would consider a minimum reserve to be around three months’ salary held in an instant-access cash account to which resort can be made in an emergency. However unless a client has an extremely aggressive attitude to investment risk, cash based holdings (which could be held as units in investment bonds or pension plans) should also form a significant part of an overall investment portfolio.
It may be possible to improve cash returns by committing some of your savings to fixed term deposit accounts, typically for 6 months or a year, although periods up to five years are generally available. The higher return is bought at the expense of a loss of liquidity.
UK residents can pay up to £20,000 per annum into a cash ISA which would benefit from tax-free interest.
In essence, a bond is a loan made by an individual to the government or to a company. Where it is made to the government it is known as a gilt. In return for the loan, which is repayable after a stated period, the lender receives income in the form of interest. The interest paid on a gilt is know as the coupon. Thus, a bond will deliver to the investor a steady fixed level of income irrespective of the performance of the stock market.
The safest form of bond is generally considered to be the gilt as the loan is to the British government with a firm promise of repayment of the face value of the gilt at maturity and a set level of interest for the life of the bond. Gilt terms can be between 1 and 50 years.
Although gilts cannot be encashed before the stated maturity date they can be sold on. The price that can be obtained will change daily and there is no guarantee that you will be able to sell a gilt for the same price that you bought it for.
Gilts can be purchased individually but it is more common for investors to hold them via a fund. This is also true of bonds generally. There are hundreds of funds to choose from.
The relationship between the prices of gilts and their yield is inverse. When yields from currently issued gilts fall in response to downturns in interest rates, the prices (and therefore the value) of existing gilts rise. Gilts are also seen as offering a safe haven for investors when the stock market is experiencing high volatility. However it is wrong to claim that Gilt funds are immune to volatility as they are actively traded in order to maximise gains which can also increase the risk of short to medium term losses
Bonds can be issued by companies and are known as corporate bonds. They pay a fixed interest rate, typically over a term of 7 to 10 years. They operate in a very similar way to gilts and may be sold on the market or interest can be taken until the investor redeems the bond for the original purchase price. As bonds are issued by companies and institutions you are dependant on the issuer remaining solvent while you hold the bond.
Two agencies specialise in grading the quality of bonds. Moody’s and Standard & Poor’s rate bonds on their ability to pay interest and the likelihood of the capital debt being repaid on maturity. The best rating is Aaa or AAA. The lower a bond’s credit rating, the higher the risk although an investor would expect more return in exchange for increased risk.
Property is another asset class that should always be considered as part of a diverse portfolio. It is regarded as having a low corelation with the other asset classes as it is more dependant on local factors such as supply and demand. Of course, if you own your own house a large proportion of your wealth will already be tied up in property so you should take this into account when investing in property although most of the property funds available are based on commercial property which can be a qualitatively different type of risk to residential property.
You thus have two choices if you wish to invest in commercial property: either buy an actual building or invest in a commercial property fund. For half-a-dozen or more years prior to 2007 commercial property funds showed steady and impressive gains. Volatility was extremely low, even much more stable than gilts and many were lulled into the belief that property was a secure investment. The collapse in values in 2007 wiped out five years worth of gains for many funds, a salutary reminder that substantial gains cannot be divorced from the possibility of rapid and sometimes dramatic losses.
Those wishing to invest in residential property often consider Buy-to-Let as an attractive option for deriving ongoing income from an asset that should, over time, rise in value. Being a landlord is not a risk-free occupation. This has become particularly evident in the latter part of the first decade of the 21st century as many people new to this activity have found out.
Shares, also known as equities, are stakes in the companies that issue them. Over the long-term, shares have been regarded as the best- performing asset class, giving returns greater than bonds, commercial property and cash investments. They have also experienced higher volatility than cash, bonds and property and sometimes, even over quite long terms, it is possible to demonstrate that the conventional wisdom claiming equities will inevitably outperform all other classes is unfounded, especially where an equity related investment has to deliver a return on a given day (for example a retirement date).
Equities portfolios can deliver not only growth but also income via dividend payments but it should always be remembered that if a company collapses the ordinary shareholders will be last in the queue (NB. behind bond holders) when liquidated funds are distributed
Commodities are best characterised as raw materials such as:
• Energy (e.g. Crude Oil, Heating Oil, Natural Gas)
• Base and precious metals (e.g. Gold, Platinum, Silver)
• Agricultural (e.g. Corn, Soybean, Wheat)
• Industrials (e.g. Cotton, Copper)
• Soft Commodities (e.g. Cocoa, Coffee, Sugar).
For investors willing to take a risk, or as a small part of a diversified portfolio, commodities like gold are an attractive option. The price of gold reached a record high recently. Also, until recently, the natural resources sector was riding a wave of demand from emerging economies such as China and India.
Gold, for example is considered particularly attractive in inflationary conditions. As paper money loses its value gold is seen as a safe haven – but nobody can predict with certainty if its price will continue to rise and when the bubble might be about to burst.
Investing in commodities should be approached cautiously by most investors unless they have a very aggressive attitude to risk. It is a good rule of thumb to restrict commodity exposure to just 5% of an overall portfolio.
A structured product is an investment based on derivatives that are linked to the performance of an index or asset class for a fixed period. These vehicles often provide some form of protection so that a client will get some or all of the invested capital back provided they have been held for the full term. Returns above the original investment may be paid at the end of the fixed period or as income or as a combination of the two, depending on the plan. A structured product may take the form of a capital secure arrangement where the return from the plan is not guaranteed but the capital is not at risk (provided the issuer – usually a bank – remains solvent). The more likely form that an income paying product will take is a capital at risk variant where the income level may be pre-determined but the invested capital might not be returned in full if the referenced index (eg. the FTSE All-Share) does not perform adequately. Although these products offer a means of avoiding the volatility of pure equity investment they are rarely risk-free and, as there is no established secondary market, it is very difficult to liquidate the plan prior to maturity and, even if a buyer is found, a substantial loss is always likely.
Structured products are normally created so as to ensure the proceeds returned at maturity are categorized as capital gains rather than income. However, income paid during the term may be subject to income tax at the client’s prevailing rate unless the payment is deemed to be a return of capital (in which case full return of the initial investment will be dependent on performance).
Structured products might be a suitable option for a client requiring income above the level that conventional deposits are able to produce but if a high rate of income is guaranteed it must always be stressed that capital is at risk.