One of the most important investment decisions you ever make

How you choose to allocate your wealth between different asset classes will be one of the most important investment decisions you ever make. Asset allocation can account for the majority of your portfolio returns over the long term, so it’s essential that you achieve the right balance of cash, fixed income, equities and property in your portfolio.

 

Different types of assets

If you are an income investor, you need to understand that different types of assets generate different forms of income. These can broadly be classified into three groups: fixed income, guaranteed income and variable income.

Fixed income is generated by investments that yield income payments on the basis of a fixed schedule. Bonds, whether corporate, government or anything in between, are collectively referred to as ‘fixed income investments’. The term ‘fixed’ in this case refers to a schedule of obligatory payments, not the amount of income or its predictability.

Variable income, on the other hand, cannot be predicted ahead of time and will fluctuate depending on factors such as interest rate changes, inflation rate movements or the profitability of a company. The dividend income paid by company shares can be seen as a variable form of income, as this will depend on the company’s results and profits. Rental income from a property investment will also vary over time, depending on factors such as demand and supply in the property market.

Guaranteed income is backed by a third party, such as the Government or an insurance company. As such, it is viewed as the safest form of investment income you can get, although the strength of this guarantee will depend on the party backing the investment.

Examples of investments which could fall into this category include those backed by government-backed institutions such as National Savings & Investments (NS&I) or purchasing an annuity in retirement, in which case the insurance company issuing the annuity guarantees income for the rest of your life.

Drawing a range of incomes

By holding a sensible mix of different assets, you can draw a range of incomes, each paying out at different times and in different sizes. The aggregation of these will be your portfolio income, which you can use to live off of or to supplement your active income – your salary or wage. You could also choose to reinvest this income back into your investment portfolio, thereby growing your original capital invested.

How do you decide on the right mix of assets?

There is no rigid formula, but it is worth noting that the ideal mix will differ from one individual to the next, depending on variables such as your age, wealth, investment goals, risk appetite and the amount of income you would eventually like to draw from your portfolio.

Generally, those more risk-averse will weight their portfolio’s asset allocation mix more towards the safe asset classes such as cash and bonds, while those willing to accept more risk in the search for a higher income will opt for riskier investments such as equities or property. The important thing is that you diversify your investments across a mixture of assets.

Different ‘styles’ of investing

Some assets are said to be ‘negatively correlated’, for instance, bonds and property often behave in a contrarian way to equities by offering lower, but less volatile returns. This provides a ‘safety net’ by diversifying many of the risks associated with reliance upon one particular asset. It is also important to diversify across different ‘styles’ of investing, such as growth or value investing, as well as across different sizes of companies, different sectors and different geographic regions.

Growth stocks are held as investors believe their value is likely to grow significantly over the long term, whereas value shares are held because they are regarded as being cheaper than the intrinsic worth of the companies in which they represent a stake. By mixing styles that can out- or under-perform under different economic conditions, the overall risk rating of the investment portfolio is reduced. Picking the right combination of these depends on your risk profile, so it’s essential to seek professional advice to ensure that your investment portfolio is commensurate with your attitude to investment risk.

A ‘paper loss’

The important thing to remember with investments is that even if your investment goes down, you will only actually make a loss if you cash it in at that time. When you see your investment value fall, this is known as a ‘paper loss’, as it is not a real loss until you sell. If you are going to invest, you need to be prepared to take some risk and to see at least some fall in the value of your investment.

While all investments carry an element of risk, the amount of risk you take directly affects any potential returns and losses. Generally speaking, if there is less risk to your investment, your money will grow more slowly, and with more risk your investment may fluctuate more.

Currency risk

You should also be aware of currency risk. Currencies, for example, sterling, euros, dollars and yen, move in relation to one another. If you are putting your money into investments in another country, then their value will move up and down in line with currency changes as well as the normal share-price movements.

Another consideration is the risk of inflation. Inflation means that you will need more money in the future to buy the same things as now. When investing, therefore, beating inflation is an important aim. Investing in cash may not beat inflation over the long term.