Putting together an investment portfolio
When putting together an investment portfolio, there are a number of asset classes, or types of investments, that can be combined in different ways.The starting point is cash – and the aim of employing the other asset classes is to achieve a better return than could be achieved by leaving all of the investment on deposit.
The most common types of cash investments are bank and building society savings accounts and money market funds (investment vehicles which invest in securities such as short- term bonds to enable institutions and larger personal investors to invest cash for the short term).
Money held in the bank is arguably more secure than any of the other asset classes, but it is also likely to provide the poorest return over the long term. Indeed, with inflation currently above the level of interest provided by many accounts, the real value of cash held on deposit is falling.
Your money could be eroded by the effects of inflation and tax. For example, if your account pays 1% but inflation is running at 1%, you are not making any real terms, and if your savings are taxed, that return will be reduced even further.
Bonds are effectively IOUs issued by governments or companies. In return for your initial investment, the issuer pays a pre-agreed regular return (the ’coupon’) for a fixed term, at the end of which it agrees to return your initial investment. depending on the financial strength of the issuer, bonds can be very low or relatively high risk, and the level of interest paid varies accordingly, with higher-risk issuers needing to offer more attractive coupons to attract investment.
As long as the issuer is still solvent at the time the bond matures, investors get back the initial value of the bond. However, during the life of the bond, its price will fluctuate to take account of a number of factors, including:
Interest rates – as cash is an alternative lower risk investment, the value of government bonds is particularly affected by changes in interest rates. Rising base rates will tend to lead to lower government bond prices, and vice versa.
Inflation expectations – the coupons paid by the majority of bonds do not change over time.Therefore, high inflation reduces the real value of future coupon payments, making
bonds less attractive and driving their prices lower.
Credit quality – the ability of the issuer to pay regular coupons and redeem the bonds at maturity is a key consideration for bond investors. Higher risk bonds such as corporate bonds are susceptible to changes in the perceived credit worthiness of the issuer.
Quities, or shares in companies, are regarded as riskier investments than bonds, but they also tend to produce superior returns over the long term.They are riskier because, in the event of a company getting into financial difficulty, bond holders rank ahead of equity holders when the remaining cash is distributed. However, their superior long-term returns come from the fact that, unlike a bond, which matures at the same price at which it was issued, share prices can rise dramatically as a company grows.
Returns from equities are made up of changes in the share price and, in some cases, dividends paid by the company to its investors. Share prices fluctuate constantly as a result of factors such as:
Company profits – by buying shares, you are effectively investing in the future profitability of a company, so the operating outlook for the business is of paramount importance. Higher profits are likely to lead to a higher share price and/or increased dividends, whereas sustained losses could place the dividend or even the long-term viability of the business in jeopardy.
Economic background – companies perform best in an environment of healthy economic growth, modest inflation and low interest rates.A poor outlook for growth could suggest waning demand for the company’s products or services. High inflation could impact companies in the form of increased input prices, although in some cases, companies may be able to pass this on to consumers. Rising interest rates could put strain on companies that have borrowed heavily to grow the business.
Investor sentiment – as higher risk assets, equities are susceptible to changes in investor sentiment. deterioration
in risk appetite normally sees share prices fall, while a turn to positive sentiment can see equity markets rise sharply.
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Information is based on our current understanding of taxation legislation and regulations. Any levels and bases of, and reliefs from, taxation are subject to change.Tax treatment is based on individual
circumstances and may be subject to change in the future. Although endeavours have been made to provide accurate and timely information, Lloyd & Co cannot guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No individual or company should act upon such information without receiving appropriate professional advice after a thorough review of their particular situation.We cannot accept responsibility for any loss as a result of acts or omissions.