A key benefit of commodities for investors is their low performance correlation with other asset classes. Indeed, many commodity sub-sectors do not even have a high correlation with each other. So, a diversified selection of commodities can provide a useful way of managing risk within your portfolio. As commodities are physical, tangible assets, many investors perceive them to be a safer investment option than the intangible options. However, they would not be suitable for income investors as there is no ‘dividend’ as there is with some equities.

In recent years, the strength of some commodity prices have been boosted by demand from global powerhouses such as India and China and this demand looks set to continue. However, those same commodities have also been blamed for causing rising inflation (when demand exceeds supply this can create inflationary pressures as prices are driven up by those most desperate to buy). Since there is strong demand but a finite supply of most commodities, this may continue to be a problem until alternatives are found.

As a UK investor, you can invest directly in commodities, although this isn’t really practical for most – after all, where would you store a million tonnes of copper? Even in professional circles, most commodities trading is typically done using futures and options, as these allow investors to speculate on prices of future deliveries before they arrive.

For the average investor, however, there are pooled products which invest in a range of different commodities, or gain exposure to the sector through the shares of companies operating in it. Finally, you could choose funds that target commodities sector stocks. But remember, even if you just own a FTSE 100 tracker fund, you will already have some exposure as oil and mining stocks are well represented amongst the largest in the UK. You don’t want to end up over-exposed without realising it.

• “I knew it was going to be bad but I’d already bought the ticket”.
• “I’m not investing money into that until the value has gone up 20%”
• “I’ll sell it when it gets back to the price I paid”.

Why do we behave irrationally? Why do we sit in a cinema watching a bad film just because we bought the ticket? Are we not simply suffering the consequences twice? We would not wait for the price of our morning coffee to go up 20% before buying it, so why do we do this with investments? Why do we hold onto things which have dropped in price, when selling them and moving on would get our money back quicker?

Many theories abound. Right back to economists like Adam Smith, many have sought an explanation of why markets behave as they do. One that has gathered force of late is behavioural finance.

Behavioural finance suggests people often make decisions based on so-called rules of thumb, rather than after rational analysis. Technically referred to as heuristics, it involves understanding that the way a problem is presented to a decision maker can affect the outcome (a process called framing) and market inefficiencies are not the only way to explain outcomes that go against rational expectations.

Two of the most influential psychologists in the field are Daniel Kahneman and Amos Tversky who, in 1979, published a paper comparing models of rational economic behaviour with decision-making during times of risk and uncertainty. Their theories sought to explain anomalies in the way investors and financial markets react.

These theories help to explain how we can all get pulled into phenomenon such as the technology boom (usually too late to actually make money), despite the irrational theories which often support them. It helps explain why we sell out of a falling market, just when our loss is at its greatest. It explains why we hold on to ‘loved’ investments. And it is why we shy away from markets which have underperformed, despite indications of great potential.

Increasingly, asset managers are using pricing models to take behavioural biases into account, as they believe it gives them an advantage. If you understand these theories, you could have that advantage too. It can be difficult to turn your head against the herd when it is stampeding towards you at full speed – but long-term, you may be very glad you did.

Given the recent market volatility, potential investors would be forgiven for thinking the best place for their money would be under the bed.

Whilst this has the obvious plus point that, barring a burglary, you will get your money back when you need it; it is likely to leave you poorer over the long-term.

Why invest?

• FIRSTLY AND MOST IMPORTANTLY, CASH DOES NOT PROTECT AGAINST INFLATION. DESPITE A RELATIVELY BENIGN INFLATIONARY ENVIRONMENT, A POUND STILL BUYS YOU A LOT LESS NOW THAN IT DID TWENTY YEARS AGO.
• SECONDLY, IF YOU ARE INVESTING FOR THE LONG TERM, TAKING MORE RISK COULD ACTUALLY BRING YOU GREATER RETURNS. IN FACT, EVEN IF YOU PUT YOUR MONEY IN A DECENT DEPOSIT ACCOUNT,YOU ARE STILL LESS LIKELY TO REACH YOUR LONG TERM INVESTMENT GOALS THAN IF YOU INVEST IN EQUITIES AND/OR BONDS.

In theory, this is all very well but equities, bonds and the income that they earn, may go down in value as well as up. How do you go about ensuring you get the best return you can, whilst also ensuring you don’t lose the lot?

The answer is diversification- and this guide provides an introduction to the theory which can help you make the most of that opportunity.

What is diversification?

DIVERSIFICATION IS DEFINED AS THE SPREADING OF YOUR PORTFOLIO ACROSS DIFFERENT ASSET CLASSES, INCLUDING EQUITIES, BONDS, PROPERTY, ALTERNATIVES AND CASH. THE MAIN OBJECTIVE IS TO REDUCE THE RISK IN YOUR PORTFOLIO COMPARED WITH THAT OF INVESTING IN JUST ONE TYPE OF INVESTMENT.

In theory, the fact that your investment is spread across different types of asset classes means that when one asset is underperforming, the positive performance of another asset will help to compensate for it. In this way, your portfolio will be able to provide positive returns – or smaller negative returns – than if it were all invested in the single underperformer.

The long term nature of portfolio planning means that all asset classes are likely to have their ups and downs from time to time. Diversification means you don’t have to get wrapped up in worrying about which one you should be in – or out of – at any particular time.

Cash

Cash provides security of capital and an income which varies with interest rates. It is therefore a good idea to hold a decent amount of money in cash for your short-term needs. However, holding large sums in cash over the long term may actually prove to be risky, simply because the real value of your money – i.e.: its ability to buy a given basket of goods – can reduce over time. For the cautious amongst us, there are ways you can manage your cash better to reduce this risk. First, shop around and ensure you are getting the best rate on your savings. Note that National Savings & Investments can offer inflation-linked certificates, albeit at a lower initial rate of interest. Money market funds might also offer higher rates of interest (and therefore greater potential for inflation protection) than a normal deposit account.

Bonds

Bonds are generally accepted as the next step up, from cash, in terms of risk. They are designed to provide investors with a fixed level of income (interest) and then full return of capital on a pre-agreed future maturity date. Consequently, during the life of a bond, if interest rates go up, an existing bond becomes less attractive and its capital value on paper will fall. Conversely, if interest rates go down, an existing bond paying higher interest will become more attractive and its capital value would therefore go up. Despite their accepted position towards the lower end of the risk scale, the asset class contains many different types of bond, offering quite different levels of risk and potential reward:

Different Types of Bonds

Government bonds

As the name suggests, these are bonds issued by governments. In the UK, these are known as gilts and in the US, as treasuries or T-bonds. Government bonds are loans issued to fund public spending or investment. In return for lending money, the investor receives their pre-agreed rate of interest and is repaid their capital on the pre-fixed maturity date, perhaps 15+ years in the future. Gilts are considered amongst the lowest risk of all bonds because the UK Government is considered a highly credit worthy borrower who has never defaulted on interest payments to investors. However, not all government bonds are the same. Higher risk governments also issue bonds and there have been notable disasters. The most recent was Argentina, where the Government defaulted on its obligations during the economic crisis of 1999-2002. Russia has done the same and emerging market countries are also considered to be outside the remit of any investor seeking stability and long term reassurance.

Corporate bonds

Corporate bonds are loans issued by companies, usually for future development or investment (take-over) opportunities. Like governments, companies pay investors a pre-agreed rate of interest over the life of the bond and then pay back the original capital investment in full at maturity. The amount of interest paid by a company will be based on the current level of interest rates and the risk of the company going bust. Different companies will have differing levels of existing borrowing, different prospects and different credit histories, each of which affects the way investors assess the risk. The higher that overall risk, the more the company will have to pay to attract investors.

To help less informed investors make decisions, most bonds are rated by independent agencies such as Standard & Poor’s or Moody’s. Generally, bonds from a highly credit worthy company with a good history will win an A++ or AAA rating, with the grading then scaling down alphabetically through A, BBB, B, CCC and below. As an overview, any company or bond rated AAA, AA, A or BBB is classified as ‘investment grade’. Those rated BB and below are considered ‘high yield’ because their risk levels mean higher interest payments are needed to attract investors. At the bottom of the scale, CCC and below, these bonds should be avoided by all but the most adventurous and experienced investors. They can carry a default risk in excess of 50% and are sometimes referred to as ‘junk bonds’.

Property

Property is generally seen as the next risk level up on the scale. For many investors, the exposure provided by their own property might be considered enough. However, for those looking to extend their exposure, or who want a medium risk investment opportunity which might also provide a decent income, property offers its own benefits. There are two types –commercial and residential – and they behave in slightly different ways. Commercial property is property used by businesses and is split into three main types – retail, industrial and offices. It offers a consistent, long-term income stream, based on long term rental/lease agreements, with the possibility of some capital growth depending on demand. Individual properties are high value investments with long lead times and therefore most individual investors access this sector via mutual funds. Residential property has a lower ticket value and slightly shorter lead times (although still a matter of weeks). Buy-to-let provides rental based income but leases are shorter and capital values are reliant on individual tastes – which can impact values widely, even within the same street. Whichever option you go for, property must be considered as a long term investment and future returns should not be expected to be as high as they have been in recent years. The commercial sector in particular is very specialist and it is therefore recommended that advice is sought from an expert before any decision is made.

Equities

Equities are probably the best known asset, even if they are not the most widely understood. When you buy an equity, you buy a small share in a company and the value of that share will then become reliant both on the performance of the company concerned and on sentiment within the market as a whole. Equities are considered high risk because their prices are volatile, varying constantly as investor sentiment shifts. Even when the performance of a company individually might be good, if the outlook for the economy is negative, the share price could fall as wider pessimism stops investors from buying.  However, over the long-term, equities have consistently provided higher returns than the other asset classes. According to Barclays Capital (1), an investor who put £100 into the stock market in 1899 and reinvested the income they earned would now be worth – in today’s terms, i.e.: after all adjustments for inflation – £25,000. If that same £100 had been placed in gilts, it would be worth just £323, or if it had been kept in cash, it would have increased to just £286.

This is of course, based on an average investment across the stock market where corporate profits tend to outperform inflation over the long term. Short term, however, there will be some years when this is the case and others when they miss targets, the latter of which will cause prices to fall. In addition, even while the overall market does well, there will be individual companies which do badly. There are also sub sectors which carry a greater risk, such as smaller companies or those in emerging markets. Equities should not be considered unless you are comfortable with what these ups and downs might mean for your investment over shorter periods.
(1)Barclays Capital Equity Gilt study 2007

Alternative asset classes

One final way to improve the investment mix of your portfolio is to include alternative asset classes. However, these are only suggested for the most sophisticated of investors as they also, individually, carry a significantly high – and sometimes a difficult to understand – level of risk. Any alternative asset class should only make up a relatively small part of your portfolio.

Alternative assets might include hedge funds, private equity, wine, art, classic cars and antiques. All are very specialist areas, distinct from each other. Even within the single term ‘hedge fund’ you will find an enormous range of different investing strategies from hundreds of different funds, some of which may be based in unregulated, offshore environments with no transparency and little come back if things go wrong.

Achieving diversification – ‘Core and Satellite’

CORE AND SATELLITE IS AN EASY TO UNDERSTAND APPROACH WHICH WILL CREATE A DIVERSIFIED PORTFOLIO.

Basically, this means building a safer, long-term investment as a ‘core’ and then adding on racier investments around the edge. The riskier ‘satellite’ investments can be shifted around more actively as market conditions change. However, while this works to reduce an investors’ vulnerability to individual holdings, there are certain risks, particularly in the equity market, which this strategy won’t address. In the last bear market, sophisticated investors didn’t lose as much money as their less skillful rivals, but they still lost money. The only way to shore up the performance of a portfolio in a declining equity market is to ensure you also hold other, uncorrelated assets. It used to be that investors could diversify UK equities by simply investing in foreign markets. But global markets increasingly move in line with each other, often following the lead of the US. Now investors have to look further afield. Returns from government bonds and investment grade corporate bonds are only lightly correlated with equity markets. Their prices will tend to move according to the interest rate cycle and, in the case of corporate bonds, investors perception of the likelihood of default. This means the inclusion of investment grade corporate bonds and government bonds in a portfolio can help lower the risks and smooth out the returns of an otherwise purely equity portfolio. Clearly there have been times when both equity and bond markets have fallen at the same time. This is when property, cash and alternative asset classes come into their own. These can generate – or simply consolidate returns when the rest of your portfolio is suffering. Of course, there is also danger in too much diversification as you could diversify away all your excess return. A balanced portfolio, appropriate for your age, expectations and attitude to risk, is the ideal way to begin investing.

Building your portfolio

Now you know the asset classes, you need to work out how they will fit together to best achieve your goals

Here the process becomes quite personal as the exact mix will depend on your age, the term of your investment, your goals and your attitude to risk.

If you are investing for the long term, perhaps for a pension, then you should probably hold more of your portfolio in high-growth assets such as equities. You can then shift progressively into lower risk assets such as bonds or cash as you draw nearer to retirement, so a sudden downturn in the equity market does dent your pension at the last minute.

In practical terms, the premise of diversification is simple. If you have twenty shares and one goes bust, you still have 95% of your money. For this reason, collective investment funds are a useful tool as your money is pooled with that of other investors and managed by a professional fund manager. These can provide you with access to the fortunes of perhaps 50 or 100 shares for a relatively small sum.

Building your Portfolio-the process in summary

1. Consider the investment amount
2. Know your investment timescale
3. Assess your attitude to risk
4. Take account of your personal circumstances
5. Allocate proportions of your investment to different asset classes
6. Select underlying investment funds
7. Review your position on a regular basis

Further information

This guide can only ever act as an introduction to the complexities of diversification
and portfolio building. However, if it has raised your interest and you would like some
help to look at your own investment goals; we can help you review your own situation
in detail.

Bond Returns

A corporate bond pays a fixed rate of interest (coupon) in much the same way as a gilt. The coupon measures this income as a percentage of the nominal value of the bond. The nominal value of the bond is its redemption value. However, generally, the current price of a bond in the market is different from its nominal value, so it is important to consider the actual return the investment offers, rather than just the coupon.

For example, consider a (fictitious) corporate bond issued by XZY plc, with a coupon of 5% per year of the nominal value, so a holding of £10,000 nominal value of the bond would provide an income of £500 per year (usually, but not always, paid in two half yearly instalments). This is the gross income and it is important to note that the income is taxed as savings income and is paid after deduction of 20% tax at source. Obviously, if a company was making the investment, any tax due would be at the company corporation tax level for both income and capital gains.

Where the bond is purchased on the market, its price will depend on a number of factors, which I will cover later, and may be more or less than the nominal value. Suppose that the current market price of a holding of  £10,000 nominal of XYZ plc bond is £10,800, the coupon is 5% but the actual yield to the investor will be less, because he has paid more than the nominal value.

The income yield (also known by a variety of other names, including the running yield or income yield) measures the income as a percentage of the purchase price. In this case the interest yield would be:

£500 x 100 = 4.630%
£10,800

Although the interest yield gives a better indication than the coupon of the actual yield to the investor, it does not give the complete picture. If the investor pays £10,800, and holds the bond until redemption, he will have a certain capital loss of £800, because the redemption value will only be £10,000. This therefore needs to be factored in to the calculation of what is known as the redemption yield.

Redemption Yield

Suppose the redemption date is five years away. One method of approximating the redemption yield is sometimes called the Japanese method, and rests on a simple interest calculation rather than a compound interest calculation. The approach is to take the gain or loss that would occur on redemption and divide it by the period remaining. The result is then used as an adjustment to the interest yield.

In the above example, the loss at redemption is £800, which represents a percentage loss over five years of:
£800 x 100 = 7.407%
£10,800

The adjustment to the annual yield is therefore 7.407% divided by 5 = 1.481% so the approximate redemption yield is 4.630% – 1.481% = 3.149% pa.

A more precise calculation based on the exact timing of each payment to the investor would yield a slightly different result, but generally the difference is not great.  In the example used, if we assume the income payments are half yearly, the actual redemption yield is approximately 3.27%pa, so the estimate give above is quite good.

Points to be aware of

The yield to investors depends on the price of the corporate bond and clearly a major factor affecting this is the level of market interest rates. An investor will only buy a bond if the return is commensurate with that available elsewhere, so when interest rates are high, he will require a similarly high yield from the bond, which implies a relatively low price. In the same way bond prices tend to rise as interest rates fall.

There are however a number of other factors which come into play. As well as interest rates, inflation levels will also affect the attraction of bonds and therefore their price. Because the income derived, and the eventual redemption value, are fixed in monetary terms, their real value will be eroded by high levels of inflation, which will therefore reduce bond prices.

Economic conditions generally will also impact on anticipated interest rates and therefore bond prices. For example, in a conventional economic cycle, a high government borrowing requirement will usually mean that interest rates will rise. In our current economic cycle we have high levels of government borrowing and yet interest rates are the lowest since records began!

The attractiveness of other asset classes will influence bond prices too, because although the market in fixed interest securities is huge, it is still influenced by supply and demand.

The volatility in the price of bonds is generally less than that of equities, reflecting their relatively lower risk nature. In general longer dated bonds i.e. those with the greatest remaining period to redemption, are more volatile than short dated bonds. This reflects the greater impact of market interest rates over the longer period.

Bonds with a relatively low coupon are also more volatile than those with higher coupon, because any movement in market interest rates will have a greater proportionate effect.

Specific Risk Factors

Companies issuing bonds are rated by credit ratings agencies, including Moody’s and Standard and Poor’s. This provides a basis on which investors can get an indication of relative risk and so consider the attraction of a particular bond investment. The greater the level of risk the market feels a particular corporate bond entails, the greater the yield will be and the lower the price.

A wide range of factors are taken into account in the grading, including profitability and cash flow, and the overall extent of borrowing by the company concerned.

Over time, the perceived prospects for a particular company will change, and this will affect the pricing of the bond. If prospects improve, the price of the bond will increase and the yield reduce, relative to the current price (the fixed monetary level of income for an existing investor does not change of course). This creates the potential for a capital gain for the investor; however, there is also the potential for loss if the bond is downgraded and the price falls as a result.