Spreading your risk
Asset classes and diversification
An asset class is a category of investments, or economic resources, that shares typical features and behaves in a similar way. Each asset type has its own level of risk and return and will perform differently in any given market environment.
Types of asset
Cash deposited in banks or building societies earns interest and is the least risky asset type, although its buying power can fall over time due to inflation.
Bonds and Gilts (also known as fixed-interest securities) are loans to companies and governments respectively. They pay interest over a fixed term and the original loan is repaid at the end of the term. They tend to be classed as lower risk than shares but their value can be affected by the financial strength of the issuing company/government and interest rates.
Property includes residential and commercial property, which can be invested in directly or indirectly. Indirect investment in property could include a property-linked Unit Trust invested in commercial property. The risk and potential returns are generally higher than bonds or cash, but the limited market and time needed to buy and sell properties can mean that property takes longer to cash in.
Shares allow investors to own a share of a particular company and benefit from a share of any income or capital paid. They carry a greater risk than the asset classes above and their value can be affected by the financial stability of the company as well as economic circumstances in general. However, they do have the potential for greater returns.
Commodities are physical goods, like gold, oil and crops. The prices of commodities can rise and fall widely due to unpredictable events, including natural disasters and political unrest, so they carry a greater risk than shares. Having said this, their prices can move in different directions to other assets, so holding commodities alongside shares and bonds can help to balance your portfolio.
You may not want to put all your eggs in one basket. Diversifying by choosing different types of investment and asset types can help to manage your exposure to risk. This is because holding a range of assets in different sectors and markets can help to balance out the ups and downs of the stock market, as any poor performance by some investments may be offset by gains in others, which may reduce the risk of loss.
Investing in managed funds can be an easy way to build a diversified portfolio as they tend to include a variety of asset types.