Types of Investment - A simple explanation

Aug 3, 2018 12:00:00 PM

If you are thinking about investing surplus cash - maybe for retirement, for education planning or simply to make your money work harder given the low interest rates available - you will want to consider a range of different options.

A well diversified portfolio of investments will protect your wealth from the inevitable market cycles and allow your money to grow safely and steadily. However, the financial world is notorious for using complicated jargon which can be unfathomable and somewhat off-putting to the non-professional investor.

This brief guide is designed to explain simply in layman’s terms each type of investment and the pros and cons of each. As with all things financial we strongly recommend you discuss with your financial adviser who will be able to guide and advise you on the suitability and correctness of your investment choices.

There are 6 main investment types which are called asset classes, each has different benefits and risks and a portfolio should combine a combination of all or some:

  • Cash
  • Fixed Interest (also called fixed income or bonds)
  • Shares (also called Stocks)
  • Funds
  • Property
  • Alternatives

Defensive Investments focus on a regular income over time rather than growth and, traditionally, have mainly comprised of cash deposits and fixed interest.

Cash deposits are interest paying savings accounts which are seen as having little risk. Current low interest rates have meant that this type of investment is struggling to give returns above inflation, which means the real purchasing value of your money could decrease over time. The other major risk is the creditworthiness of the bank or institution where the money is deposited. Most countries offer a government guarantee of a certain amount in the event that the institution becomes insolvent. In the UK this is set at £100,000 per individual per institution, so if you had a number of accounts that exceeded that figure with one bank, your guarantee is only for the £100k.

Fixed Interest comprises of term deposits, Government bonds and Corporate bonds.

A term deposit is simply a cash deposit that cannot be accessed for the duration of the term. As they are less liquid than a cash deposit, the interest rates are traditionally slightly higher.

A Bond is simply a loan certificate issued by Governments or companies who, in exchange for the ‘loan’, pay a set rate of interest over regular periods for the fixed period of the Bond. At the maturity of the Bond the capital is fully repaid to the investor. Bonds are generally quoted in price terms or yield. The yield reflects the return on the investment and the price and the yield are inversely correlated: higher the price, the lower the yield and vice versa. All bonds carry a ‘rating’ from one or more of the recognised agencies who evaluate the creditworthiness of the issuer (borrower). Top rated bonds are seen as low risk investments, however the recent economic policies of quantitive easing (simply governments buying bonds to add cash into the economic system) have meant that the yields have fallen to historic low levels and leave investors with very low returns.

Traditionally, bonds have been seen as the defensive part of a portfolio that is unaffected by the ups and downs of the stock markets. More recently, this has not been the case and even top quality bonds have seen high volatility in uncertain times.

Higher yield and emerging market bonds are much higher risk investments and should only be considered by experienced investors.

I am going to include Gold and precious metais / stones as a footnote to defensive investments. People look to buy gold in times of crisis when they believe the financial system is under strain and gold will offer a last ditch intrinsic value. In truth it is expensive to buy and sell with huge commissions payable to the dealers, whilst over time its returns have been very poor vs inflation.

Growth Investments

The aim of these is to increase in value over time although they may also pay out income. The returns are much higher but the prices of these instruments can fluctuate wildly at times and therefore the risk of loss is much higher.

The main types of growth investments are shares and property.

A share or stock is simply a single unit of ownership in a company. Shares are bought and sold via an exchange. In the recent past these were predominantly transacted between physical individuals but normally now the exchanges are electronic.

Buying a share is done with the belief that the value of that company will rise, perhaps through long term growth or short term speculation. Companies that make profits may also pay a dividend on each share which is essentially an income payment as a reward for investing; the dividends can be reinvested or taken as cash.

Blue Chips refer to large established companies with both a history of growth and of paying dividends.

Stock markets have given higher returns over the medium and long term than almost any other investment. Stock markets are also called stock indices (ie FTSE100, S&P500) and are made up of baskets of the largest stocks normally by company valuation. Remember that although a stock market might rise for example by 20% over a few years, the companies that make up the indices will change. Some will have grown but some companies will not and will have been replaced in the index by growing companies.

There are many ways to trade stocks but individual investment directly into shares requires knowledge and - most importantly - time to fully analyse each company on a daily or highly regular basis, and to access to the necessary information. An investment fund holding 30 to 50 stocks may have 25 full-time employees to do the research, hence single stock investing is not generally advised except for the professional or sophisticated investor.

Funds

Funds are essentially baskets of assets. They can be wholly invested in one asset class or across many. They offer a way to access a pool of investment that is managed by a professional team who have all the analysis and information needed to make informed investment decisions.

They are split into ‘Passive’, which track the underlying index and ‘Active’, which are invested based on the investment views of the team managing the fund.

There are literally thousands of funds but it is important to do your due diligence on the ones you choose. There are many funds who, to quote the newspapers, couldn’t beat a monkey investing, but there are many fund managers who have delivered consistent returns over a long period. Knowing the strategy, the manager, the performance and, most importantly, the risk management of each fund invested in, is key to a successful portfolio.

ETFs are essentially stock baskets and can be a cheap way to invest into a particular market. They are considered Passive investments.

Funds are recommended for the average investor as most of the due diligence and investment decisions are made by the fund manager. It is also possible to invest a small amount of money in a fund whereas to recreate the same portfolio would require a far greater amount of investment and cost.

Property

Most people understand the notion of investing in ‘bricks and mortar’ and although property is seen as a safe or defensive investment, it is classed as a growth investment. Property is split into residential and commercial property, although in recent times it has also become possible to invest in different forms such as hotel rooms.

New forms of letting, such as Airbnb, have seen an explosion in investors focused on the short term returns available. However, legislation can have a massive effect on the potential returns if letting periods are curtailed or banned.

Historically, property has been seen as a way to counter inflation as property prices have generally kept pace with - or outstripped - the rises in cost of living. Property prices can bubble and burst so the timing of the investment is important and the old adage of location location location is very true.

The problem with property has always been liquidity and although it is an advised part of a portfolio it cannot always be sold quickly if cash is needed. Therefore, it is generally a very long term investment.

Property investment is very specialised as different countries have very different taxation structures, and an incorrect investment structure can lead to serious liabilities if not managed properly. An example is the recent changes in property taxation in the UK which has left many buy to let investors with potential losses after tax.

Alternatives

Alternatives cover a vast array of less traditional investments such as Hedge Funds and Structured Products to classic cars and art.

Classic cars have actually been one of the best performing investments of recent times but like art, it is highly speculative and can require huge sums of money to purchase a collection. There have been many attempts to set up funds for cars, art and even wine to allow lower entry levels of investment but these have been bedevilled by high fees, lack of liquidity and fraud.

Hedge funds can have very interesting strategies but are very complex and not easy to fully understand. The initial level of investment is generally also high and these are recommended for professional or sophisticated investors only.

We will fully cover structured notes in a separate article but in brief these are derivative instruments based on a certain set of underlying criteria. They can be used as an alternative to traditional income investment or as a way of protecting against volatility in markets.

A well diversified portfolio of the appropriate asset classes to your goals and risk tolerances will protect your wealth and allow it to grow safely over the medium to long term.

Please look out for our next article in the investment series which will focus on how to build a successful portfolio and the pitfalls to avoid.

 

Stuart Nelson

Written by Stuart Nelson