Asset classes to suit your risk
As the saying goes, a journey of 1,000 miles begins with a single step. Deciding to invest is the first step of the investment journey, but in the context of 1,000 miles, it's a pretty small one.
Choosing which assets to invest in is, by comparison, a much bigger decision, and with a huge range on offer, it's important to get to grips with each asset type.
At the safest end of the spectrum are bonds. These are loans made to either governments or companies. In return, they pay you a fixed rate of interest and agree to pay the loan back at the end of a set period.
As a general rule, the more risky the loan's considered to be, the more interest you'll be paid on it. UK government bonds, or gilts, are generally considered the lowest risk – as the UK government is very unlikely to fail. Other governments, however, are less secure.
Loans to big, reliable, blue-chip companies with good products and relatively strong balance sheets are next along the risk spectrum, and are known as investment-grade bonds.
Loans of this sort will pay slightly more interest than those to governments, as they are deemed to be more risky.
Further along the scale come less well-established or well-resourced companies, which are considered somewhat less secure.
The higher the risk that the firm will default or fail to repay its debt, the more interest it will have to pay to persuade people to lend money to it.
Riskier companies issue what are known as high-yield or junk bonds – there's a huge range of risk with these.
Also relatively low on the risk spectrum is commercial property. This involves buying properties such as warehouses, shops and offices, which are then rented out to businesses.
Traditionally, this is a reasonably pedestrian investment. You may enjoy small rises in the underlying value of the property, but the focus is on the rental income, preferably from good, reli-able companies on long lets.
This sector has recently been through an unusual period, with abnormally high rises in the values of the properties – so much so that the performance of these investments started attracting interest from those who normally seek out higher-risk/higher-return options – followed by dramatic falls.
However, some advisers think commercial property is beginning to follow a more typical pattern again.
Gavin Haynes, managing director of Whitechurch Securities, explains: "Over the long-term, 70% of the total return from commercial property investing comes from income, and I believe that interest in the sector from investors seeking yield and portfolio diversification will revert to normal levels."
Things start to get riskier with shares, or equities. These are units of investment in a company, which rise and fall with the demand for, and supply of, the shares.
If it's a popular company doing well, its share price will go up, and if it starts doing particularly badly and everyone is convinced the firm is doomed, share prices will fall. Within this class, again, there is a tremendous range of options.
At the relatively low-risk end are the large blue-chips, with long histories, reliable order books and a commitment to paying dividends.
These payouts, when reinvested, form the bedrock of returns, as they keep paying out even in tougher times, and can help boost total returns in flat or slightly falling markets.
Dividend-paying companies will make up the stocks in an equity income fund. They will, however, show less growth than their smaller, nimbler counterparts, which may be at the earlier stages of expansion and could double in value overnight.
After this, in terms of risk, come the broader UK funds, which invest in a mix of both small and larger UK companies.
This is followed by global growth funds, smaller companies funds and funds based in established overseas markets like Europe and the US. Next there are funds in emerging markets, like Brazil, Russia, India and China.
And finally there are niche funds, either investing in a single emerging market, such as China, or a single industry – a technology or healthcare fund, for example.
"Volatility is endemic in stockmarket investment," says Haynes. However, this is more pronounced towards the riskier end of investment, in particular in emerging markets that are largely influenced by sentiment and investor risk-tolerance.
An emerging markets fund, for example, could increase 20% in a year, but could just as easily fall by the same margin. In recent years, falls of 40% or more have not been uncommon.
BALANCE OF ASSETS
You can opt for a single asset class, but you don't have to. There are plenty of investment funds that will invest in a combination of asset classes.
They range from cautious managed funds, which tend to invest in a mixture of bonds and equities, to multi-asset funds, which can take their pick and time their investments so as to weight the fund towards those asset classes most likely to do well in the fund manager's view.
Your balance of assets will depend on where your attitude to risk sits on the risk spectrum. The variety of funds on the market means it should be possible to use a range of established retail funds to buy into the assets you choose, in the proportions that exactly suit your needs.
It will mean researching the manager's record and approach, and the make-up of each fund, but there is a range of tools available online from sites like trustnet.co.uk or our sister website iii.co.uk to help you understand exactly what your funds are investing in.
Once you've chosen your assets, you will have taken a massive leap forward on your investment journey. But a first step plus a massive leap still leaves you some way to go in that 1,000 mile journey.
The next step is to pick the kind of investment vehicle that suits you. There is, of course, the high-risk option of going for a single asset – a single share, a single office block, a single bond – but this does not spread your risk and therefore leaves you very vulnerable. Haynes says this route isn't recommended for those with less than £500,000 to invest.
The usual approach, as already discussed, is through some kind of collective investment. You pay your money in, it's pooled with that of other investors, and then an expert will invest it for you across a range of holdings.
There are two major classes of these collective investments: investment trusts and unit trusts.
You can invest from as little as £20 a month into regular saving schemes from certain unit trust providers such as Invesco. But if you can afford to invest £100 a month you'll have access to a wide choice of unit and investment trust regular saving schemes.
Either of these options can be placed inside a stocks and shares individual savings account. These allow up to £10,200 to be saved tax-efficiently each tax year. Investors pay no income tax on dividend payouts, and also, when the investment's cashed in, it will be free of capital gains tax.
CGT rises to 28% from April 2011 and will apply to any gain worth over £10,100, so it's well worth protecting your investments in an ISA.
Darius McDermott, managing director of Chelsea Financial Services, recommends...
Marlborough Special Situations invests largely in UK companies, and those that for some reason are being undervalued by the market. It is a higher-risk fund than other core UK funds, but offers great potential in return.
Fidelity Special Situations has long been one of the most successful UK funds, and attracted huge sums under former manager Anthony Bolton. The running of the fund was subsequently taken on by Sanjeev Shah in January 2008, and he has impressed investors during his time at the helm.
Invesco High Income fund is the third choice on McDermott's buy list. It's managed by Neil Woodford, whose reputation is unequalled in this space.
Patrick Connolly, an adviser with AWD Chase De Vere, recommends...
M&G Global Leaders is a globally diversified fund. It invests in undervalued large companies showing signs of improvement that are not yet reflected in the share price.
Invesco Perpetual Tactical Bond fund invests in either high-yield or high-quality bonds, depending on which part of the bond market seems best value.
Investment trusts are companies that invest money in other companies and whose shares are listed on the London Stock Exchange. As with unit trusts, private investors buying shares in an investment trust are buying into a diversified portfolio of assets (to reduce risk), which is managed by a professional fund manager. Investment trusts differ from unit trusts in two important ways: they are listed on the stockmarket and so are owned by their shareholders and are closed-ended funds with a finite number of shares in issue. This means the share price of investment trusts might not reflect the true value of the assets in the company (known as the net asset value, or NAV) and if the NAV value of a share is £1 and the share price in the market is 90p, the trust is said to be running a discount of 10% to NAV. But this means the investor is paying 90p to gain exposure to £1 of assets. Investment trusts can also borrow money and use this money to buy investments. This is known as gearing and a geared trust is thought to be more of an investment risk than an ungeared one.
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.
A collective investment vehicle (known in the US as a “mutual” or “pooled” fund) and similar to an Oeic and investment trust in that it manages financial securities on behalf of small investors who, by investing, pool their resources giving combined benefits of diversification and economies of scale. Investors buy “units” in the fund that have a proportional exposure to all the assets in the fund, and are bought and sold from the fund manager. The price of units is determined by the value of the assets in the fund and will rise or fall in line with the value of those assets. Like Oeics (but unlike investment trusts) unit trusts and are “open ended” funds, meaning that the size of each fund can vary according to supply and demand of the units form investors. Unit trusts have two prices; the higher “offer” price you pay to invest and the “bid” price, which is the lower price you receive when you sell. The difference between the two prices is commonly known as the bid/offer spread.
An individual employed by an institution to manage an investment fund (unit trust, investment trust, pension fund or hedge fund) to meet pre-determined objectives (usually to generate capital growth or maximise income) in prescribed geographic areas or investment sectors (such as UK smaller companies, technology or commodities). The manager also carries the responsibility for general fund supervision, as well as monitoring the daily trading activity and also developing investment strategies to manage the risk profile of the fund.
If you own shares in a company, you’re entitled to a slice of the profits and these are paid as dividends on top of any capital growth in the shares’ value. The amount of the dividend is down to the board of directors (who can decide not to pay a dividend and reinvest any profits in the company) and they will be paid twice yearly (announced at the AGM and six months later as an interim). Dividends are always declared as a sum of money rather than a percentage of the share’s price. Although dividends automatically receive a 10% tax credit from HM Revenue & Customs (HMRC), which takes the company having already paid corporation tax on its profits into account. Dividends are classed as income and, as such, are liable for personal taxation and so shareholders have to declare them to HMRC.
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
Capital gains tax
If you buy an asset – shares, a second home, arts and antiques – and then sell it at a later date and make a profit, that profit could be subject to CGT. You don’t pay CGT on selling your main home (which is why MPs “flipped” theirs so regularly) or any securities sheltered in an ISA. Individuals get an annual CGT allowance (£10,600 in 2010/2011) but if you have substantial assets it’s worth paying an accountant to sort it for you.
The familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.