Which assets should I invest in?
Once you've decided on your attitude to risk, you'll need to think about which assets should make up your portfolio. In this guide we'll explain the four main asset classes, and look at some examples of portfolios constructed to meet low, medium and high risk tolerances.
What are the main asset classes?
There are four main asset classes, which can be combined in your portfolio to achieve your desired level of risk and stand the best chance of meeting your investment goals:
- Cash: Cash investments such as Cash ISAs and savings accounts are considered the least risky of the four, but tend to produce lower returns. That’s why there is is still some risk, namely inflation risk: if inflation runs higher than your interest rate, the value of your money can be eroded.
- Bonds: A bond is essentially a unit of debt issued by a government or company. If you hold bonds you receive a coupon (interest payment) and there is a maturity date (when your capital is returned). Bonds are bought and sold via the stock market, similarly to shares. Some government bonds are considered less risky than corporate bonds, as it is less likely that a government will go bust. UK government bonds are called Gilts.
- Property: This involves investing in residential or commercial property, with the aim of generating returns through rental income and increasing property value. This is considered more risky than cash and bonds, as the property market can fluctuate.
- Equities: Otherwise known as stocks and shares. This is generally viewed as the most risky asset class, as returns depend on the stock markets, which can be unstable. Investing in UK equities is seen as slightly lower risk than US equities, with stocks and shares from "emerging markets" – such as China and Brazil – considered the most risky.
You also have the option to invest in commodities. This means investing in precious metals such as gold and palladium, raw materials such as copper and steel, as well as agricultural industries. You can gain exposure to commodities through commodity funds. Although returns can be significant, commodities markets are notoriously volatile, so this should be considered a high risk strategy.
Example asset allocations for different risk levels
Below are some examples of portfolio constructions for each level of risk. The pie charts show the combination of different assets in each portfolio, and the expected real returns (after inflation) are also listed.
Jargon buster: Sometimes you'll see "volatility" in relation to investment portfolios. Volatility is a measure of uncertainty about fluctuations in an asset's value. A higher volatility means the price of the security can change dramatically over a short time period in either direction. A lower volatility means the value does not fluctuate dramatically, but changes at a steady pace over time.
Estimated real return: 3.8% per year
Avoiding loss is a priority for the low risk investor, so this portfolio is weighted towards traditionally lower risk assets such as UK gilts and cash. There is some exposure to equities for higher potential returns, but the focus is on the UK stock exchange rather than more volatile global markets.
Estimated real return: 5% per year
This portfolio includes more exposure to equities, with no reliance on cash. There is some exposure to emerging markets, where the potential returns (and risks) can be higher. However, there is still some exposure to less risky options such as UK gilts and global government bonds.
Expected real return: 6.1% per year
This portfolio is geared towards the pursuit of high returns through exposure to equities, including those in emerging markets. There is still a small amount of exposure to bonds and gilts, but the majority of the portfolio is held in higher risk assets.
Choosing investment funds
If you want to build your own portfolio by investing in a combination of funds, the aim is to combine asset classes in order to balance risk and potential returns at a level you're comfortable with. You can choose funds focused on, for example:
- A particular asset class, such as UK equities or bonds
- A particular sector, such as smaller or mid-sized company shares
- A particular territory, such as Europe, Japan or emerging markets
- A particular investment goal, such as capital growth or income.
Investing in a multi-asset or multi-manager fund means that the fund manager does the hard work of asset allocation for you. You simply need to select a fund that matches your investment goals and attitude to risk.
Similarly, if you use a discretionary management service, they will select a portfolio of funds that matches your stated aims and risk tolerance, and manage the asset allocation for you.
About the calculations we've used
The suggested asset allocations and projected returns have been carefully researched and formulated by the team of investment experts at Momentum Global Investment Management.
The research team at Momentum are specialists in multi-asset investing. The portfolio asset allocation models have been through thorough scenario testing across a range of economic outcomes, and the returns have been analysed based on asset returns and volatility since 1991.
The projected returns have been adjusted to account for the effects of inflation, and provide and expected real return assuming a long run inflation rate of 2.25%. They do not include the effects of tax on investment income, capital gains or alterations to your asset allocation in the future.
Last updated: 05 February 2016