YOUR MONEY; Don't lose your balance
In the second of a series for novice investors, Anthony Bailey shows how to mix safety with risk taking
Sunday 08 October 1995
But taking some risks should mean bigger returns. And by building up a diversified portfolio of investments, you spread the risk. The idea is that even if you do a Leeson with some of your investments, the performance of the rest will act as a counterbalance.
Bank and building society deposits may not be classed as a "risk" investment, but there is a risk involved - apart from the fact that the institution holding your money may collapse. The risk is that the real value of your money - including interest - will fail to keep up with inflation.
Putting money into a balanced portfolio of investments should protect its real value against inflation as well as achieving a return over and above inflation.
Inevitably, the first part of any portfolio will be in so-called "cash" investments. That means money on deposit or in a cash unit trust or National Savings. A key element of a cash investment is that the nominal value of your money will not fall. Put in pounds 1,000, and you expect to get pounds 1,000 back, plus interest.
But other types of investment should increase returns and meet your other requirements. Some investors want the maximum income immediately. Others can afford to draw a lower income now to achieve higher income and capital growth later. Others are happy to lock their money away and draw no income, in which case they can put the emphasis on capital growth.
There are two main categories of investment that can be used to achieve these various aims - fixed-interest securities (bonds) and shares (equities).
Fixed-interest investments. These are generally considered to be a lower risk than shares, good for producing relatively high incomes but not for capital growth.
Fixed-interest securities or bonds are a form of IOU, with you as the lender. During the life of the bond, the holder is paid a regular income, usually twice a year. At the end of the bond's life - which could be 5, 10 or 15 years - the issue price, called par (for example pounds 100) is generally repaid.
Gilts. The gilts market accounts for a large part of the fixed-interest securities activity in the UK. Gilts are IOUs issued by the government to fund its borrowing requirement. The UK government is unlikely to default on these loans. But during the life of a gilt, its price can rise or fall above and below its final value, influenced by several factors including changes in interest rates and expectations for inflation. So unless you hold a gilt to maturity, you cannot be sure of what you will get back.
Corporate bonds. Foreign governments also issue bonds and so do private companies. This year has seen the promotion to private investors of the corporate bond - IOUs issued by companies. Unlike gilts, these can now be held in a tax-free personal equity plan (PEP). Their yield (the income) is often higher than that of gilts, reflecting the greater risk of investing in a private company.
Shares. Further up the risk scale come shares. But they differ hugely. Some will pay quite high dividends. Others pay virtually none, and the return comes in the form of the rising value of the shares as a company grows.
Most private investors will opt first for relative safety - shares in large, established, "blue-chip" UK companies. They carry a lower risk than other shares, but the reward is also likely to be lower. Beyond these there is a huge range of risk.
Investing abroad. This provides further opportunities to diversify and spread risk in case UK markets do badly. The pound may also fall and increase the sterling value of investments held in a foreign currency.
The pooled investment. In practice, many investors find that with both bonds and shares, they have insufficient funds to spread the risk, or lack the expertise. That is where unit and investment trusts can help.
These collective investments provide a ready-made portfolio, pooling small sums of money from individual investors to spread risk across a range of holdings. But the risk is spread only within the limits of a fund's investment remit. This could be to invest in corporate bonds, the shares of leading companies, or potentially high-growth smaller company shares.
But investing in just one unit trust does not really represent a diversified portfolio. So how do you achieve a sensible balance?
Next week, we ask professional investment managers how they allocate investors' money around various markets and types of investments.
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