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Investment Overview
Deposit accounts
This area is ideal for short-term savings where access is required at short notice, and flexibility is the most important issue. Everybody should maintain a reasonable sum in deposit accounts for emergency purposes if nothing else. We usually recommend no less than two months' income. Cash or deposit accounts are often regarded as low risk, but they are by no means risk-free. Inflation, for example, reduces the purchasing power of cash as it increases the value of goods and services over time. This means that the real value of investments held on deposit could decrease over time. There is also the "opportunity cost" of not being invested in other types of investment - you lose the opportunity to potentially receive more elsewhere. The disadvantage of this area is that the interest paid is not very high and over the longer term has struggled to even match inflation. Therefore, once a suitably sized emergency fund has been accumulated, it is sensible to look at alternatives for better returns.
Gilts and BondsGilts are issued by the Government when it needs to borrow money. Since the Government has so far yet to default on repayment, gilts are considered to be secure investments. There are different types of gilt which are issued at different points in time and for different terms to redemption. Some gilts are designed to link with inflation- these are called "index linked" gilts. Many low risk investors chose to invest in bonds or fixed interest securities. When investing in bonds you are effectively lending money to a company or a Government for a fixed term. In return for your loan, these entities pay a fixed rate of interest, usually at regular periods, and buy back the bond when it matures. The benefit of this type of investment is that the investor receives a fixed income. The risk is that the company may default and you may not get back all or any of your original investment.
A bond is effectively an "IOU" issued by either a Government or Corporation. In return for your investment, the issuer delivers an agreed level of income in the form of a fixed rate of interest (coupon). At an agreed date, the Government or Corporation will return the face value (issue price) of the bond, known as the maturity value. You pay a premium to buy the bond and receive a "coupon", which is the yearly interest payment, in return, for the duration of the bond. The premium is paid back to you at the maturity of the bond.
Different Types of Fixed Interest Security
Bonds with a rating of BB (S&P) or Ba (Moody's) or below are speculative investments. They are called High Yield Bonds, or Junk Bonds and are considered highly volatile, but can potentially offer more growth. Such bonds are issued by start up companies, companies that have had financial problems or are in a particularly competitive or volatile market and those featuring aggressive financial policies.
The US Treasury Bond market is the largest in the world and is guaranteed by the US Government. French Government Bonds are called OATs, German Government Bonds are known as Bundesrepublikanleihe, or Bunds.
Gilts are issued by the UK Government to cover deficits.
Factors which affect the price of bonds
Bond prices are highly susceptible to changes in interest rates. When interest rates rise, new bond issues come to the market with higher yields than older bonds, making those older ones worth less. Hence, their price goes down. Conversely, when interest rates decline, new bond issues come to the market with lower yields than older bonds, making those older, higher yielding ones worth more. Hence their price goes up.
Bonds are also vulnerable to inflationary pressures. The interest rate paid to bondholders is fixed at a rate determined on issue. Consequently, if inflation rises, the "income" received from the bond actually becomes worth less, as goods and services become more expensive. Inflation is one of the most influential forces on interest rates. Rising inflation often leads to rising interest rates, which reduce bond prices. Conversely, deflation would result in a lowering of interest rates, which would increase the price of bonds.
The length of time to maturity has a bearing on the yield. This is because over a longer period of time, bonds are at more risk of being subject to inflation or interest rate rises. In addition, over a long term, there is increased risk that a company's financial strength can deteriorate. These factors mean that investors will demand a higher yield to reflect the additional risks.
Whilst bonds are associated with cautious investment strategies, there are risk factors in addition to the inflation and interest rate risks outlined above to which bonds are subjected which need to be understood by the investor. Corporate Bonds are subject to credit risk which means that losses can result following a deterioration in the financial health of the issuing company. Bonds rated with a credit quality of "BBB" or above by Standard & Poor's are widely regarded as "investment grade". Higher risk corporate bonds are rated "BB" or lower and are considered to be "non-investment grade" bonds which carry a higher "default risk" where the issuing company fails to meet payment of the bond's coupon or cannot repay the bond's face value at maturity. Hence there is a spectrum of risk within the corporate bond sector with better rewards, but higher risk with bonds with lower credit ratings.
The complexities of yields and credit ratings can detract from the benefits which investing in bonds can bring to any well diversified investment portfolio. Bonds can provide a "hedge" against equity underperformance. This is because bond returns are not highly correlated with those of equities. Hence, if equity prices fall, bonds will not always follow suit. As such, when combined with other investment vehicles, they can be a useful diversification tool.
Equities
The price of a company trading on a stock market is a reflection of its value as determined by the supply and demand for the shares. When buying the shares of a company, the investor effectively buys a part of the company and its future profits or losses. Investors receive a share of the company's profit in the form of a dividend payment- they can also benefit from a future rise in the company's share price.
Within the category "equities", there are lots of very different types of equity funds which have different characteristics, objectives and risk ratings. For example, there is a "cap spectrum", which means different sizes of listed companies which, generally speaking, become less volatile and risky as you move up the spectrum from small to medium and up to large cap shares. This is because large companies tend to be less prone to wide fluctuations in value compared to small start ups. There are also different types of shares which vary according to their income and growth characteristics. For example, income stocks are characterised by established companies which have a history of returning value to shareholders by paying dividends. By contrast, growth stocks tend to return value to shareholders by increases to the capital value of the shares. Profits tend to be re- invested to grow the business rather than being paid out as dividends.
There are also different styles of fund management which focus on different behaviour characteristics of shares. For instance, "value" investing focuses on shares which have been sold off and are trading at lower prices than previously. This can be interpreted by a Fund Manager as a "buying opportunity", or a "recovery, or special situation". Other styles of fund management include growth investing where a fund manager looks for shares which have been buoyant and invests in order to catch momentum which has built up as the share has increased in value. "Defensive" stocks tend to be in sectors where demand is likely to remain constant, regardless of whether or not there is a recession or economic prosperity. Examples of defensive stocks include utilities and tobacco. There are also "specialist" funds which may invest in particular industry sectors, such as healthcare, pharmaceuticals, telecommunications, natural resources or commercial property.
Many funds are concentrated in a specific geographical area such as North America, the Far East, Europe and Emerging Markets. These are often considered to be inherently more risky than comparable UK Equity funds since whilst the underlying assets themselves may have similar levels of volatility, there are exchange rate fluctuations which add to the risk and can work in your favour, or against you. In geographical regions prone to wide fluctuations in exchange rates, this additional layer of risk can be extremely significant. Nevertheless, diversification across different geographical regions can hedge the overall risk of a portfolio and avoid the assets from being overweight in UK Equities- or "UK centric". Investing in a small number of individual equities is a high risk strategy. Exposure to risk can be reduced by spreading the risk across different sectors, asset categories and geographical location. By achieving greater diversification, it is possible to reduce the overall vulnerability of a portfolio. Provided the portfolio is sufficiently diversified, investing in equities may be more suited to someone willing to accept medium or high risk investments.
Nobody can predict the stockmarket and it is wise to choose a diversified portfolio of shares in different companies, across different sectors. Stock picking individual shares can be challenging and time consuming. The most effective way for most people to invest in the stockmarket is via collective investment schemes, where the decisions as to which shares to buy, sell or hold are made by a Fund Manager. With collective funds, your money is pooled together with other investor's money so that a broad portfolio of shares can be invested in and are actively managed on your behalf.
