Why it pays to spread your money around

For canny investors, it's worth having a diverse portfolio. James Daley looks at the options

Although stock markets have historically provided investors with the best long-term returns, there's much to be said for allocating at least a small amount of your investment portfolio to other types of assets – such as bonds, property and commodities. Each of these have a very low correlation with equities, meaning that when the shares in your portfolio are falling in value (as they probably have been over the past few months), you will at least still have some investments that are continuing to grow.

Andrew Wilson, the head of investments at Towry Law, the financial advisers, says statistics show that 90 per cent of variability in investment portfolios can be accounted for by asset allocation. In other words, getting the right mix of assets in your portfolio is far more important than picking the very best individual funds or stocks.

For example, for an investor with a high appetite for risk, Wilson says he would allocate around 65 to 70 per cent into a mix of equity funds, around 13 per cent into government bonds (or gilts) and around 13 per cent into commercial property. When the weightings drift too far away from their starting point – perhaps because equities have fallen in value and now represent less of the overall portfolio – Wilson says he rebalances clients' portfolios by using the additional returns from other assets to buy more shares while their values are low.

"By taking the profits from one asset class, and putting them into the asset class that has dropped, you can dig your way out of holes much quicker," he says.

Non-equity assets are also good for those who want to try to outstrip the returns they might get in a cash savings account, but are unwilling to take on the risk of the equity markets.

Bonds

Bonds are used by companies and governments as a means of borrowing from investors. In return, investors receive a regular income, before getting back all their original capital at a pre-determined date in the future (providing the company or government doesn't go bust beforehand).

In reality, however, small private investors do not have any direct dealings with companies or governments when it comes to investing in bonds. Instead, the best way to get access to this market is by investing in a bond fund, where a professional manager will buy a portfolio of bonds on your behalf, and trade them with a view to generating you the best possible return.

In the corporate world, there are two types of bonds – investment-grade and high yield (also known as junk). Investment-grade bonds are those issued by larger companies with strong credit ratings, who are very unlikely to default on their repayments. As a result, they tend to pay a relatively low return. Junk bonds are those issued by companies with poorer credit ratings, and pay a much higher yield due to the higher level of risk that investors are taking on.

Governments are also very unlikely to default, hence their bonds will pay relatively lower rates of interest, with yields typically dependent on money market rates, and the rate of inflation.

Although many financial advisers believe that corporate bonds should play a major part in lower-risk portfolios, Wilson says he prefers to put more of his clients' money into gilts.

But Darius McDermott, of Chelsea Financial Services, another independent financial adviser, says he prefers strategic bond funds, which use a combination of investment-grade, high-yield and government bonds. He picks out Strategic Bond funds managed by Henderson and Artemis as two of the best in the sector. Philippa Gee of IFA Torquil Clark agrees, also picking out F&C's strategic bond fund.

Commercial property

Although commercial property (offices, shops, warehouses) has performed dreadfully over the past year – falling faster and further than equity markets in many cases – historically it has proved to have very little correlation with equity markets.

Until recently, it wasn't possible to put commercial property investments into an ISA, but changes in the rules have now increased the possibilities. "Of course property has been receiving a great deal of negative attention at present," says Gee. "However, the facts remain that this is a useful diversification tool and one many should look to include as part of their portfolio.

"But don't go in assuming superior returns with low risk, as that will simply not happen. Instead, expect moderate growth from an investment that will move at different times to bonds and equities."

Gee says that while some sophisticated investors have been moving back into UK commercial property over the past few weeks, she currently favours overseas markets, and recommends New Star's International Property fund as a good pick. She also names First State's Global Property Securities and Schroder's Global Property Securities as other funds to consider – although these invest mainly in property-related shares so are likely to be more volatile.

Commodities

Commodities is a broad term used to describe everything from precious metals to agricultural produce. And until recently, it was almost impossible for small private investors to put their money directly into the sector.

Funds such as Blackrock's Gold & General and World Mining Trust have been in existence for many years, but these mainly invest in mining- and metal-related shares, and have only a small amount invested directly in the commodities themselves.

However, the strong growth in the price of metals over the past few years – driven by meteoric growth in countries such as China, India and Brazil – has increased investors' appetites. And a couple of years ago, a firm called ETF Securities (www.etfsecurities.com) launched a range of Exchange Traded Funds, which give private investors the chance to get direct exposure to movements in the price of metals or other commodities.

Will Rhind of ETF Securities says commodities have no correlation to equities, so provide an excellent diversifier for the average portfolio. Since the start of the year, for example, agricultural commodities such as sugar, coffee and wheat have increased in price, as have most precious and base metals. During the same period, the FTSE 100 index has fallen more than 5 per cent.

Wilson already holds a small amount of gold in his client portfolios, and is investigating the possibility of using other commodities.

However, Gee feels that commodity ETFs would not be suitable for the average investor.

MULTI-ASSET FUNDS

For wealthier investors – those with more than £100,000 to invest – companies such as Towry Law (www.towrylaw.com) will construct bespoke portfolios, ensuring that your investments are diversified across a number of different asset classes.

However, for those with less money to spare, Darius McDermott of Chelsea Financial Services suggests trying a multi-asset fund, which invests across the whole spectrum of asset classes and aims to be a one-stop shop for investors. He picks out Insight's Diversified Target Return Fund and Newton Phoenix, which both invest across equities, bonds, property and commodities – as well as other asset classes such as hedge funds and private equity. "After the carnage in the equity markets over the past few weeks, these funds have fallen a lot less," he says. "For example, the average UK All Companies fund is down more than 10 per cent since the start of the year, while the Insight Diversified Return fund is down just 1.3 per cent."

McDermott warns, however, that multi-asset funds can have slightly higher charges than regular equity funds. Nevertheless, even after charges, both the Newton and Insight fund have performed much better than the average equity index over the past year.

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