Behavioural finance has an increasingly central part in conversations about investment risk, since managing emotional responses plays a key role in maximising returns.
A guide to one of the key concepts behind building a successful investment portfolio and a popular piece of wealth management jargon too!
The term “asset class” describes a particular a type of investment. The most common asset classes to invest in are equities (shares), fixed income (bonds) and cash. However, there are also “alternative” asset classes such as funds and other more esoteric ones such as art and collectibles.
Typically, an equity investor buys and holds shares of a company listed on a stock market like the FTSE. Equity investors are often referred to as “owning” a particular company – and they do, if only a very small part of the business. Equity investing can boost your wealth in two main ways: by the company doing well and its share price therefore rising on the stockmarket and/or by it paying out regular dividends to investors from its profits.
Shareholders usually get voting rights to be exercised when big corporate decisions come up, however their influence will clearly be proportionate the size of their shareholding (which will likely be tiny in the grand scheme of things). Shares are a familiar asset class and watching the markets can be very interesting. But their appeal is tempered by the fact that if a company goes bankrupt equity investors are usually at the bottom of the pile when it comes to getting their money back. Your adviser will be able to select investment prospects for your portfolio which are precisely aligned with your risk appetite.
A bond represents a debt that company, government or other “debt issuer” owes to an investor. During the term of the investment the issuer pays a form of interest to the investor called a coupon before eventually – assuming all goes well – paying back the principal amount invested.
Issuers use bonds to raise money for long-term investments, which could be an acquisition in the case of a company or a big infrastructure project in the case of a country. Investors are drawn to the stability offered by fixed income; the time until the bond’s maturity is fixed, as is its return. Yet bonds do still carry some investment risk and there is in fact a whole risk spectrum for fixed income, from “junk” bonds at one end to bonds issued by the most financially strong economies and companies at the other
The amount of risk a bond represents essentially reflects the likelihood that the issuer will renege on repaying the principle. It used to be virtually unthinkable that a developed country would go bust, but recent events have illustrated the folly in that assumption. Company bankruptcies are of course more common and if they default on their loans investors can be left with nothing. Your wealth manager will have plenty of advice about which fixed income investments are safest.
Holding cash on deposit at a bank is the traditional, safe way to store wealth. The bank takes your money and guarantees its safety while lending it out or otherwise investing it for its own purposes. In return, the depositor receives a regular interest payment.
One of the principal allures of cash is its liquidity, meaning the ease with which money can be got back out. But this is not necessarily the case; if a troubled institution experiences a “bank run” then it may not have sufficient reserves to return funds to everyone at once. There are safety measures in place, however, and the UK government guarantees deposits of up to £85,000 (at each institution an investor places money with). Investors looking to put more than that amount on deposit should consider diversifying their wealth across more than one institution – a significant proportion the investors coming to findaWEALTHMANAGER.com are looking to do just that.
Cash is very low-risk but when interest rates are low and inflation is running high investors can find the real value of their money eroding away. There are likely to be far more attractive investment options for them to explore.
The term “alternatives” covers a wide array of assets. These may be physical assets such as property or commodities (like gold, oil or corn); the term also refers to investment activities like hedge funds or private equity. It can even refer to investment in a geographic region like emerging markets.
Investing in alternatives can be rewarding, but it can also carry significant risks. Success is highly dependent on the skill of the person selecting the investments and their market-timing abilities. Some of the most esoteric investments, like art or fine wine, require a huge amount of expertise
One of the great things about alternatives is that they are often uncorrelated to traditional asset classes – meaning that can continue to perform well when cash, equities or fixed income are not. Diversifying your wealth among asset classes is foundational to protecting and growing your wealth, and alternatives could serve a useful purpose in your portfolio. Taking expert advice is crucial, however. A professional wealth manager will only deploy alternative investments when appropriate for your profile and risk appetite.