Ok So you know you need a portfolio of investments, but what does that mean?
At its most basic, a portfolio is a selection of investment classes that you’ve chosen in the hope that they will grow in value and in time provide you with a passive income. How you go about selecting your portfolio is an entirely personal choice depending on factors such as age and aversion to risk, but there is a common basket of investment types that most investors will hold. Anything else is just a variation on this.
These common forms of investment are stocks, bonds, commodities and property (real estate).
Let’s start with probably the biggest group – stocks (just so you know the difference you buy a share of a stock). Also commonly referred to as equities in the investing world, this is one of the simplest investments for the average person to acquire, with some of the largest potential gains but also the largest potential losses. When you buy an equity you’re buying a little piece of a company and you take ownership of that little piece. So when the value of the company goes up, so does the value of your share.
But the reverse is also true. If the value goes down then the hard-earned money that you’ve paid for the share will decrease too. What you’re aiming for is to replicate what traders have been doing for hundreds of years, which is to buy shares when the price is low, and sell when the price is high.
The difference between the low and high price is your profit – minus the stockbroker fees of course. One bonus with investing in equities is that some companies pay out dividends for each share that you own. A dividend is a percentage of the value of the share which is often paid out when a company is very large and isn’t growing so much anymore, but is still producing profits. The company will want to retain their shareholders so they pay out dividends in lieu of capital growth of the shares.
I’ve held stocks of individual companies over the last couple of years and have made some profits and made some losses, but for me personally I get very nervous about the volatility of buying shares in individual companies. It was whilst looking for ways to reduce the risk that I came across funds, which are a selection of companies grouped together into one ‘pot’, which you can then purchase a part of. The bonus of this is that there is diversification built-in, so that if the value of one company falls it could be offset by an increase in the value of another. What I eventually settled on was building a selection of Investment Trusts which are a type of fund and something we’ll cover in another article.
Bonds are a little bit more complicated. Basically, a bond is a type of loan whereby you lend a company or even the government some money and they give you a bond (known as a ‘Corporate Bond’ if it’s from a company and a ‘Gilt’ if it’s from the UK government). They will then promise to repay you the amount that you’ve lent them after a set amount of time, but they will also pay you regular interest (known as the coupon) on the amount of money that you’ve lent them.
Generally, bonds are considered to be a safer form of investment (especially government-backed bonds) than equities, and they have the added bonus that if the stock market falls the returns on your bond remains fixed.
Remember the old adage never to put all your eggs in one basket? Well, that’s the first rule of building your portfolio. You want to position it so that if one investment falls there’s a very good chance that another will remain stable to even things out.
Of course, you’ll get different rates of interest depending on the amount of risk you’re willing to take. Lending money to the UK government could be considered to be the safest form of investment, as it’s pretty much guaranteed you’ll get your money back, whereas lending to a small company is riskier as they could go out of business and you lose your money. Therefore for accepting the higher level of risk, the company will pay a higher rate of interest, and the government will pay you a lower level of interest for their bond.
It’s down to you to decide on the ratio of equities to bonds that you want to invest in, based on the level of risk you want to take and the timeframe you have to invest in.
For example, if you have 30 years to grow your wealth you can afford to invest more in equities because the increased volatility will even out over time. So maybe 80% of your portfolio can be in shares. However, if you’re nearing retirement then you’ll want to keep as much of your hard-earned money as possible without worrying about the ups and downs of the stock market, so you’ll probably want to invest more heavily in bonds.
Note that there’s been talk in the financial press lately about this being the end of the bull run for bonds. This will be the topic of a future discussion, but you can continue our round-up of investment classes in Part 2 of this article.