Diversification and asset allocation

Some people put all their investment eggs in one basket. But if they chose a relatively high-risk investment then when volatility strikes, prices may drop and panic them into selling, crystallising their losses. And of course, if they choose an investment that’s too low risk, they may find that even in good times, they're not chasing the returns that they could, or the investment is not growing enough to counteract the effects of inflation eroding its value. Seasoned investors understand that successful long-term investing depends on the right mix of assets and so they diversify across asset types and across geographies. They mix shares, bonds, cash and other asset types to achieve a profile that matches their appetite for risk. If they don't have the time or knowledge to manage these investments themselves they may even just buy a fund that will do it for them. Seasoned investors know that when volatility strikes, an appropriately diversified portfolio minimises the impact of a single asset type, and can even help take advantage of opportunities.

Also known as stocks and shares, when you invest in equities you buy a small stake in a company with the aim of capital growth, dividend income, or a blend of the two. When you buy a share in a company, you’re actually buying a piece of that company. The investment return you earn depends on the success or failure of the company itself. Equity funds have the ability to invest in a range of companies, based on a particular fund manager’s expert insight and experience, spreading the risk across a number of holdings and accessing multiple opportunities on your behalf.

Potential benefits:

• You could receive dividends (a share of earnings) to reinvest or provide a regular income
• Equities often hold the greatest potential for capital growth

Things to consider:

• As an asset class, equities carry the greatest risk in the pursuit of reward. They can prove volatile in the short term.

The value of investments and the income from them can go down as well as up, so you may get back less than you invest.

Bonds are corporate and government loans with you playing the part of the lender, in exchange for interest payments over a set period. Through issuing a bond, a company or government can borrow money in exchange for paying a fixed interest over a set time period, along with paying the initial amount back at the end. When you invest in bonds you are the lender and benefit from regular payments over the life of the bond. You can also choose to invest in a bond or income fund or select a multi-asset income fund. These funds invest in various asset classes to generate an attractive income, diversified across a number of securities. The multi-asset approach also benefits from diversification among asset classes, with the intention of reducing the overall risk of the portfolio.

Potential benefits:

• Interest is fixed and paid regularly
• The value of a bond on the open market may go up
• Paying interest on bonds is a higher priority for companies than paying dividends

Things to consider:

• Corporate bonds can be less secure than government bonds and gilts
• The value of a bond on the open market may go down

The value of investments and the income from them can do down as well as up, so you may get back less than you invest. For funds that invest in bonds, please be aware that the price of bonds is influenced by movements in interest rates, changes in the credit rating of bond issuers, and other factors such as inflation and market dynamics. In general, as interest rates rise the price of a bond will fall. The risk of default is based on the issuer's ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between different government issuers as well as between different corporate issuers.

A commodity is a basic good like steel or oil that is most often used in the production of other goods or services. You can invest in commodity funds, which will often include mining and production companies, or track the performance of a specific commodity in the world market through a specialised ETF. Their value fluctuates according to current market supply and demand, as well as views on their future prospects. You can invest in a range of commodity funds which focus mainly on those companies involved in energy, metals & mining and paper & forestry products.

Potential benefits:

• One of the few asset classes that can benefit from rising inflation
• Can help diversify a portfolio as commodity performance will often move in the opposite direction to equities in times of volatility

Things to consider:

• High risk asset class
• As material goods, commodities do not provide an income
• Difficult to predict in the short term

The value of investments and the income from them can go down as well as up, so you may get back less than you invest.

Property funds often invest in commercial property rather than the residential market but you should still consider your house and any buy-to-let properties you own as part of your investment portfolio. Property funds benefit from the ability to invest in large commercial projects like shopping centres and retail parks. Fund managers can commit more capital to these properties and deal with fewer landlords than investing in residential schemes, as a result. Property funds also allow investors to invest smaller amounts than would be necessary to buy a physical asset.

Potential benefits:

• You can invest smaller amounts in a fund than would be required to buy a physical property.
• With daily dealing it is often easier to buy and sell a fund than a property.
• You can access the commercial property market in a fund, an opportunity not available to most personal investors buying directly into physical property.
• In a fund your money is spread over different properties and sometimes different countries, rather than one physical asset.
• Funds take away the responsibility of maintaining a property. You don’t have to handle property deals and maintenance.

Things to consider:

• In times of market volatility, property funds may suspend trading so they can sell assets to meet redemption demand. 
• Property prices may fall.
• Changes in currency exchange rates may affect the value of overseas investment.

The value of investments and the income from them can go down as well as up, so you may get back less than you invest.

Carrying the lowest investment risk of the five assets, cash can be a useful asset to hold within a portfolio for a number of reasons. First, its inherently low investment risk provides good diversification to riskier assets. Second, holding cash allows you to take advantage of market dips, investing at the low point. Third, easily accessible savings held in cash can cover sudden unforeseen circumstances, without having to sell better performing assets.

Potential benefits:

• Carrying a low level of investment risk, cash offers good diversification opportunities when twinned with riskier assets
• Quick and easy access to your money

Things to consider:

• Inflation can reduce your money's real value
• The value of investments and the income from them can go down as well as up, so you may get back less than you invest.