What do you see when you think of an ‘investor’? It’s easy to visualise a well-heeled person in a sharp suit clutching a financial newspaper, but the truth is very different.
By Alistair McQueen
Most investors are like you and me - people who have a pension or a stocks-and-shares ISA. So it makes sense to build a little knowledge about the terminology you might come across - especially during periods of heightened market volatility like we’re seeing today.
Although you may invest in different asset classes, it’s actually the fund that directly invests in the asset, not you. So in this article, ‘investing’ refers to you investing in the fund, and the fund investing in the assets. For example, any rental income from a property fund or dividends from shares are paid to the fund rather than directly to you.
We’ll look at the four main types of assets into which you could invest.
Spoiler alert: It would be wrong to conclude that one asset class is universally better than another. Each has their place, depending on your investment objectives. It’s always a good idea to construct a balanced portfolio - where you invest in more than one asset class to help spread the risk - or invest in an investment fund that provides this for you. This is because each asset class reacts differently to the same economic and market conditions, so investing in different types will help minimise the risk of a loss if a particular asset types performs poorly.
The four asset classes
There are four main investment categories into which most of our money is invested. These are referred to as ‘asset classes’. They are:
- Cash / Money markets
- Fixed interest
Let’s start with the one that many people understand best: cash.
1. Cash / Money markets
The attraction of investing in cash is its relative safety. The value of your cash investment should be stable and in addition, you should receive interest on that money. This interest will be tax-free when in an ISA or a pension.
It’s a misconception, however, to say that the value of an investment in cash will never go down. Many investments carry an additional investment charge, including those in cash.
And when interest rates are very low, as they are today, this charge could reduce the interest payment to near zero, or even push it into the negative.
While cash typically wins when it comes to being low-risk, it is usually perceived to lose when it comes to long-term return. Interest rates on cash investments today are at historically low levels, and this low interest can be further eroded by inflation. So, while the absolute value of your cash investment may not fall, the real value – or its ‘purchasing power’ – could fall over time. For this reason, many see cash investments as a safer haven, primarily for the shorter term.
2. Fixed interest
The idea of an individual lending money to a government or a major company might seem a bit bizarre at first, but that’s essentially what fixed interest investing is.
Fixed interest investing is where the funds you invest in make a loan, either to a government or a company. In the UK, loans to the government are typically known as ‘gilts’ (UK government bonds) and loans to companies are typically known as ‘corporate bonds’. In a pension or an ISA we generally access these options by investing in a fund which then invests in a portfolio of underlying corporate bonds or gilts. The government, or company the fund you’ve invested in has lent money to, agrees to pay interest until the end of the loan term, at which point they aim to pay back the money lent to them.
The benefit of fixed interest investments is that you should get a known rate of income if you hold the investment until the loan is paid back (this is called ‘redemption’). Receiving this known income could be a good idea, for example for people who have reached retirement and have fixed expenditure for bills they need to cover.
However, there is a risk that the government or company which has borrowed the money will stop paying interest or could even default altogether. This would mean losing some, or all, of the capital lent to them, as well as the promised interest. This heightened risk typically means the return on fixed interest investments will be greater than that offered by cash investments.
The underlying gilt or bond may have a set loan term, but you don’t need to hold that investment throughout. You can typically invest or withdraw your money during the loan term, during which time the value of the gilt or bond can go down as well as up – driven by investor demand. So, while fixed interest investments are perceived to carry a degree of certainty, it remains true that you might get back less than you initially invested.
‘Equities’ is another name for shares issued by companies. They give the shareholder a stake in the ownership of a company, which may pay a dividend if the company makes a profit.
Shares are traded on exchanges such as the London Stock Exchange. The total value of all the shares issued by a company is known as its market capitalisation – in other words, how much it is worth.
You can invest directly in one company, but for many the favoured way to invest in equities is through a fund managed by an investment manager through their pension or ISA. Such funds usually invest in hundreds, or even thousands, of different companies, which helps spreads the risk.
The perceived benefit of equities is that they have historically delivered good returns over the longer term, keeping pace with inflation and providing some extra returns, and so growth in capital, on top. Some shares also pay high dividends. If sustainable, these are – like fixed income investments - a good match for known income needs.
The disadvantage of shares is that their price is volatile - their value can go up and down regularly and by large amounts, depending on market conditions. For example, drawing retirement income from a volatile savings fund could mean that you run out of money early on. And if you’re approaching retirement, a big drop in the value of equities could mean a big drop in your pension wealth if it’s all invested in equities.
When it comes to pensions, property investing means commercial property – retail units, offices and factories. Your savings are used to buy properties such as these, which are then let out to companies who pay a rental income.
Most people who invest in property do so through funds managed by investment managers through their pension or ISA. These funds invest in a large number of different commercial property types, reducing risk through diversification.
One of the big risks attached to investing in property funds is that your money could be suspended for a period. This is because the investment manager may be unable to immediately sell the commercial properties that they hold in the fund to pay cash to investors who want to leave, or because of difficulty in providing valuations for commercial property.
If you want to take an income in retirement, being unable to access your investments to take an income could be a big issue. Therefore, if you do decide to invest in property, you should also have a reasonable proportion invested in other investments from which you can draw income when economic conditions mean that your property investments are suspended.
And, like the other investment classes, the value of property can go down as well as up and you could get back less than invested.
Don’t panic, remember the long term and seek help
At times of uncertainty, it’s understandable to have a sense of worry. But when it comes to investing, it’s helpful to not let worry become panic. Investment decisions made under stress are rarely good ones.
It’s also helpful to remember the long-term nature of many investments, especially those in ISA or pensions. It’s wise to not let short term volatility dictate long-term investment decisions.
And finally, it’s often sensible to seek help. Unless you’re an experienced investor, you may choose to leave investment decisions to someone else. If you have a financial adviser, they will help you select funds that meet your financial objectives within your personal tolerance for risk. Pension providers also offer ready-made investment portfolios for do-it-yourself investors to choose from.