Introduction

Investment involves putting your money into four main asset classes: cash, fixed-interest securities (sometimes called "bonds"), property, and equities. These are individually explained further down the page.

These asset classes are not always positively correlated with each other. This means they will often rise and fall in value at different times and in different market conditions. We don’t know which of these asset classes will do the best over the next year, so we generally recommend a diversified multi-asset portfolio which contains all of them. Even cautious portfolios contain some equity exposure as the diversification into them can help reduce overall risk, and equities can help the portfolio keep up with inflation long-term. 

Many people simply associate the word “risk” with something terrible happening like “the risk of a car accident” and may initially believe they don’t want to take any risk whatsoever – that is until they understand what risk actually means in an investment context, and the fact that all investment carries some degree of risk.

One way to consider investment risk is the uncertainty of investment returns from one year to the next. In general, the rule is that the greater risk, or uncertainty, you take with your investments, the higher your potential reward (and potential loss). In this way, risk and return share a relationship.

Many people are willing and able to tolerate some investment risk with their money to meet their financial objectives. This is because most people have objectives requiring them to make their money last longer, go further, and/or keep up with inflation.

Inflation is a general increase in prices over time, and the corresponding fall in the purchasing power of money. Inflation is generally estimated to be around 2-3% per annum as measured by the Consumer Prices Index. So, if a loaf of bread costs £1 today, it will cost you around £1.02-£1.03 next year. Another way to think about this is that the value of your £1 coin has fallen to around 98p. This doesn’t seem like much but over time this is compounded, and it can quickly add up. You may remember that years ago it was much cheaper to buy a Mars Bar or a can of Coke.

As inflation continues, you’ll need more and more nominal income each year to maintain the same standard of living. Similarly, any long-term savings and investments you hold will need to grow at least in line with inflation to maintain their spending power.

Fortunately, wages tend to rise more quickly than inflation so you may find yourself with slightly more disposable income over time. Equity investments have historically outpaced inflation, and certain financial contracts, and your state pension, have built-in inflation protection.

You may already be familiar with cash. You deposit money with a bank or building society, and the bank pays you interest.

While there’s some uncertainty about interest rate movements, we can make a fairly accurate prediction as to the value of a cash deposit in five years’ time. Very slow and steady. However, it has historically failed to outpace inflation over the long term. 

Fixed interest securities, also known as bonds and gilts, are loans, usually to the government or a large company such as Coca Cola. For example, if Coca Cola wanted to launch a new drink it might fund this by issuing bonds. This might involve you and lots of   other investors, lending £100 to Coca Cola, and they’d pay you back in, say, ten years’ time. In the meantime, you’d be paid a fixed amount of interest, say £1.50, every six months. Furthermore, you can potentially sell your bond – your loan agreement with Coca Cola – at any time. A big reason companies   issue bonds rather than taking out bank loans is because they can generally borrow money more cheaply.

High quality corporate bonds issued by large, financially strong companies are sometimes seen as “one step above cash” in terms of risk. Their value – the amount of money someone will buy your loan contract from you - can fluctuate depending on several factors. Furthermore, there is usually a greater chance of a company like Coca Cola defaulting on an interest payment or not returning your capital than a bank or building society. As such, bonds are slightly riskier than cash, but can offer a higher return over the long-term to compensate investors for the additional risk. 

Property investment generally involves the investor buying property or a share in a property. The property then gets rented out, and the investment returns are the rent paid by the tenant. Over time, the property may also increase in value and may be sold for a profit.

 Property is the next step up from bonds in terms of risk, although it can be a big step. There are some big risks – uncertainties – with property, such as bad tenants and void periods where no tenants can be found. The property market can be impacted by several factors, and property is expensive and can take a long time to buy and sell. Its capital value and rental income are more uncertain – riskier – than cash and bonds from one year to the next. However, over the long-term it has the potential to outperform them as the level of rent charged is likely to be higher than the interest earned from cash or bonds, to compensate the investor for the higher risk taken.

 Equities are company shares. When you buy an equity, you are buying a tiny amount of ownership in a big company – again, like Coca Cola. If the company makes profit, you may be entitled to a share of that profit known as a dividend, and equities tend to rise in value over the long-term.

Equities carry the most uncertainty from one year to the next. It is common for companies to have bad years, not make profit, and even go out of business altogether. However, because successful companies tend to target profits above the rate of inflation, equity prices have historically risen above inflation which provides long-term capital growth. Research has shown that, over the last hundred years, equities have provided strong inflation-adjusted returns. The long-term return from equities is likely to be higher than from that of property, bonds, or cash. Another way to put this is that while we can be fairly sure of the future value of a cash deposit in five years’ time, we have no idea whatsoever about the future value of equities. 

To determine your asset allocation – the percentage amount of each asset class in your investment portfolio – we need to establish and agree your risk profile.

Higher-risk portfolios generally contain a higher percentage of equities, while lower-risk portfolios contain more bonds and cash. However, with higher risk comes the potential for higher returns (and potential losses). This is about striking a balance that’s right for you. Any investment recommendations we make for you must be suitable for your risk profile.

Your risk profile is made up of two elements:

· Your attitude to risk

· Your capacity for loss.

Your attitude to risk is how you think and feel about risk. This is subjective – it is your opinion. This may be determined using a questionnaire as a starting point to support a broader discussion, including considering risk profile descriptions, indicative gains/losses, and example asset allocations.

Your capacity for loss is the amount of money you could lose that would result in a detrimental impact to your standard of living. This is objective – it is based on mathematics. It is calculated by your Financial Adviser.

All investments carry an element of risk. Your risk profile determines how your portfolio will be constructed. Roseum Financial Planning uses "cautious", "moderately cautious", "moderate", "moderately adventurous", and "adventurous" descriptors.

Investors classified as “Cautious” will be directed towards a portfolio with low volatility and with a more certain outcome which in turn implies lower expected portfolio returns.

As your risk profile moves towards accepting more risk, it is likely that your portfolio will contain more high risk assets such as long-dated bonds and equities and the portfolio will have higher volatility. These assets with higher volatility can offer far greater growth potential than low risk assets over time but should only be bought with a long-term view and using capital you can afford to lose without compromising your financial security.

Rather than investing “directly” into the different asset classes, most Financial Advisers will recommend you invest “indirectly” via products called investment funds. The Fund Manager pools your money with all the other investors and invests it according to the fund’s published objectives and mandate. The Fund Manager takes a percentage-based fee for this service which is deducted automatically from the value of your investment.

This is known as “collective investment”. Collective investment allows you to access a highly diversified portfolio holding thousands of different positions, in places all over the world, cheaply and simply. The benefit of a diversified portfolio is that it helps reduce risk because if one company, geographical location, or sector experiences a drop in value, this may be offset by unrelated gains elsewhere in the portfolio.

Unit Trusts and OEICs are types of collective investment fund often recommended by Financial Advisers. Most investment recommendations by Roseum Financial Planning are for a portfolio of different Unit Trusts and/or OEICs.

You buy “shares” or “units” in each fund from the Fund Manager. The value of your “units” reflects the market value of your share of the fund’s assets. As the market value of the fund’s assets rises and falls with the investment markets, so too does the value of your units. In normal market conditions, units can be sold back to the Fund Manager for cash at any time if you need to access your money (although this usually takes a few working days to process).

When the underlying assets in a fund pay interest or dividends, these can either be paid out to the investor as income, or automatically reinvested. Whichever option you go for will depend on your personal circumstances and financial objectives.

Please note that even if interest and dividends are automatically reinvested, where the units/shares are not held in a tax wrapper such as a pension or ISA, they still count as taxable income for the tax year in question and should be declared on your tax return.