Are all your eggs in one basket?

Published by Jeff Salway on 12 December 2007.
Last updated on 11 August 2008

Chicken and three baskets of eggs

Unless you're a clairvoyant, you cannot know for certain which investments will perform best over the next 12 months or beyond. So, the chances are you're not going to put all your eggs in one basket, as history has proved this is a sure-fire way to kiss goodbye to your hard-earned money.

All the luck, talent and knowledge in the world cannot match the most important concept in investment - spreading your bets, or as those in investment circles put it - diversification. Put simply, this means putting your money in a broad range of investments. Spreading your equity investments across a range of sectors and countries, for example, means if one particular area falls, it doesn't drag your whole portfolio down with it.

But to achieve true diversification you need to look beyond equities to asset classes that are inversely correlated to the stockmarket - that is, when one falls, the other rises and vice versa.

"The idea is you suffer fewer losses than if you keep your money in one area, so you're achieving growth while limiting the downside," explains Jo Roberts, director of IFA "So when equities are doing well, but corporate bonds aren't, for example, you don't pile out of the latter and into the stockmarket, you just keep a sensible spread."

The extent to which you use different asset classes depends on various factors, including your needs, time to retirement and attitude to risk. But there's a core of investments that can help keep your head above water in any situation. So, what are they, and how can you get the best out of them?

1) Cash

Regardless of what else you invest in, cash has a role to play - and current high interest rates and a competitive market mean this doesn't have to be a case of making just the odd quid here and there.

The big appeal of cash is that, inflation aside, it's risk-free. So, regardless of what happens to stockmarket or house prices, your investment is safe. As long as it's in an instant access account it's also very liquid, meaning if you have an emergency you can get your hands on your money without having to cash in other investments at the wrong time.

Experts recommend keeping at least two months' salary in a savings account for a rainy day. To this end, there are plenty of accounts paying a decent rate of interest without locking up your money.

The best way to get returns from cash, however, is through individual savings accounts (ISAs) because these are tax-free. However, this option won't be open to you, of course, if you've invested the full £7,200 allowance in stocks and shares.

While it's a good idea to have some of your money in cash, it's not an ideal long-term investment. Over time, inflation takes a big chunk out of it, so if you're still a long way from retiring, you could consider moving some of it into equities (unless you have debts, which you should get rid of first). Then, as retirement approaches, cash can come increasingly into play again.

2) Fixed interest

"If you're looking for income or are naturally cautious you should always keep some money in fixed interest investments," explains Donna Bradshaw, financial planning strategist at IFG Group. "However, if you're investing for long-term growth you don't really need fixed interest until you get older and you start to consolidate your investments."

One of the safest fixed interest options is gilts - bonds issued by the Government, hence the security. But again, inflation is the biggest threat. This is where index-linked gilts are handy, as both the value of the gilt and the interest payments rise in line with prices. This option has been particularly popular with pension funds in recent years, as they provide a hedge against inflation.

Another asset winning brownie points for security is National Savings & Investments fixed interest savings certificates, according to Roberts. "These are often overlooked, but depending on your tax status and how long you are investing for, they can be useful."

The certificates are lump-sum investments held over either two or five years that earn guaranteed rates of interest. Their big selling point, however, is that they're free of both income and capital gains tax, whatever rate you normally pay.

Upping the risk level a notch, the other big fixed interest option is corporate bonds, which are inversely correlated with equities, making them a vital diversification tool. There's more to them than diversification, however, with the 2007 Barclays Equity Gilt Study revealing that, despite recent underperformance, corporate bonds have returned 6.9% over the last decade.

The risk depends on the company issuing the bonds - the safer the company, the lower the yield paid out, and vice versa. Philippa Gee, investments director at IFA Torquil Clark, says strategic bond funds are a good way of investing in different types of bond. "These move between investment-grade and high-yield corporate bonds so they're a good way of getting exposure to different bond types without adding risk."

A number of strategic bond funds have come on to the market in recent years, with F&C, Henderson and Artemis among the most prominent providers.

3) Commercial property

Commercial property has been hugely popular in recent years, with double-digit returns and new funds flooding the market. In light of the credit crunch, however, the market has slowed. This is partly because it had reached unrealistic heights - commercial property is primarily a diversification option, not a shoot-the-lights-out gamble.

But the value of commercial property lies in its diversification as, like all the best diversifiers, it has a low correlation with cash, bonds and equities. Property, when invested in directly, is also less dependent on economic trends and more on local factors, like supply and demand. This makes it a vital cog in any portfolio, reckons Roberts. "Even if returns fall commercial property has a role to play, regardless of your age or attitude to risk. It's a solid investment."

The commercial property boom has been largely UK-focused, but over the last year more investors have sought the added diversity of overseas markets, says Simon Critchlow, director of property fund management firm Seven Dials. "Global property is now accepted as an alternative asset allocation option," he explains. "It offers more variety in terms of risk and diversity. Leases are also longer in Europe, which makes it a natural source of income."

Most financial advisers suggest 5% to 10% of your portfolio in commercial property funds, with more than 10% for cautious investors or those nearing retirement.

4) Residential property

The popularity of buy-to-let in the UK has been phenomenal. And if doubts about its sustainability have arisen in recent months, the chancellor's decision to cut the capital gains tax (CGT) payable on disposals is certain to fuel it again. Instead of paying 40% CGT when cashing in profits above the annual allowance of £9,200, landlords will now pay just 18%.

But how effective is buy-to-let as a diversifier? As it doesn't correlate with any other asset classes, it ticks the main box. The latest surge in interest, for example, was partly a response to the bear market of 2000 to 2003, while it has also benefited from the public loss of confidence in pensions.

With record house price inflation thrown into the mix, the last few years have been a boom time for buy-to-let investors. But as an investment, there are sizable drawbacks. While those who bought sensibly and at the right time could now be sitting on a rather profitable investment, new investors will struggle. In addition to high house prices, the cost of borrowing has risen and that's making it tough to earn a decent income from buy-to-let. And then there's the housing market slowdown seen so far in 2008...

In fact, with rental increases lagging, many wannabe landlords will find that the rent they earn won't even be enough to pay the mortgage. That means today many property investors are relying on capital growth at a time when some forecasters are predicting a full-on crash.

Then there's the level of knowledge required. "Most people don't understand buy-to-let enough, and it's a complex area. For example, residential buy-to-let mortgages are a can of worms," says Jo Roberts. Equally, you need to be aware of your legal responsibilities as landlord - there's much more to buy-to-let than buying a property and then sitting back to watch it grow.

Finally, bear in mind that if you're a homeowner, a large chunk of your wealth will already be tied up in your home, so you probably have enough exposure to this asset class.

5) Commodities

As a way of achieving diversification from the stockmarket, investing in commodities is particularly effective, as the two assets are almost entirely uncorrelated.

Gold is especially attractive, with prices soaring in 2008 and to its highest levels since 1980. And the natural resources sector is riding a wave of demand from the emerging economies. This has helped funds such as the Blackrock Merrill Lynch Gold and General and the JP Morgan Natural Resources produce massive returns of late (263% and 558% respectively over five years).

But the sector is highly volatile. "Gold and oil are diversified but they can be very speculative, so they should make up just a very small portion of your portfolio," warns Donna Bradshaw, who recommends the JP Morgan fund.

Philippa Gee, however, believes funds investing purely in commodities are not a good idea for most investors. "Commodities are a great opportunity right now, but unless you have the time and knowledge I wouldn't recommend direct exposure - they can be very volatile."

Instead, she says funds of funds can provide some degree of exposure to commodities, with New Star's Active Portfolio a good example. Alternatively, you can access commodities through exchange traded funds - which track share indices - specialising in gold, metals and other commodities.


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