Diversification - what does it mean for you?

Types of investments

At its most simple, there are 3 main types of investments (sometimes referred to as asset types): shares, gilts and bonds and funds.

We have explained each of these in detail below, but first, the following table gives you an at-a-glance summary:

​Funds Shares​ ​Gilts & Bonds
What are they? Funds are collective investments that are professionally managed​ ​Shares are a way to invest in individual companies, giving you a chance to share in their success but the risk of losing if they fall. ​Gilts and bonds are forms of debt issued by companies and governments to raise money – if you buy them you ‘re effectively lending money to the issuer
Are they diversified? ​Yes. Your investment is split across a wide range of individual investments, spreading potential risk. No. The performance of this investment is tied to a single company, so there’s more risk involved.​ ​No. But the risk all depends on the financial strength of the issuer; it could default. Those listed as ‘investment grade’ are generally considered more secure. Lending to the UK government via gilts is considered even less risky.
How do price movements affect their value? ​If the value of one individual investment falls, this may be offset by rises in the value of other investments held in the fund. The value of your investment is directly linked to the price of a single company share which is determined by a market. If it falls or rises, so will your investment's value.​ The prices of gilts and bonds tend to move more predictably – and less suddenly – than those of company shares. You’ll be less likely to make a quick profit, but also have less chance of losing your money altogether. They are affected by movements in interest rates as when rates rise the value of bonds tends to fall.​
How risky are they? The structure of funds makes them generally lower risk than shares.​ Shares are high-risk investments because their value depends on the performance of a single company. They should only be considered as part of a large portfolio.​ ​Gilts and bonds can reduce your overall risk. Compared to shares, they tend to carry a lower level of risk but you should be aware that some bonds carry higher risk.
Who are they for?​ ​Funds are popular with a wide range of investors. New investors often choose funds while experienced investors might use them to access niche markets. ​Shares are for experienced investors with high-value investment portfolios. You need to be comfortable understanding the performance and prospects of a single company. ​Gilts and bonds will be attractive for investors who are looking for possible predictable returns, perhaps as a way of generating an income.

Shares

Companies divide their capital into units called shares. When you buy a share, you gain part ownership of that company. As a part owner you will normally be allowed a right to vote in certain circumstances on the running of the company, including in the appointment of directors who will manage the business of the company, and a right to a dividend paid from profits if the directors decide to pay one. Investors hope to benefit from rising share prices and income streams over time (i.e. payment out of a company’s profit in the form of a dividend), and can sell their shares when they choose.

If you are thinking of investing in shares, bear in mind that they do carry more risk than most other investments; this is because you rely entirely on the performance of a single company. This can offer the potential for higher returns if the company performs well, but equally you could lose your entire investment in extreme cases.

When economic conditions are positive, markets are likely to be stable and therefore companies more likely to perform well. This makes investors more confident, and can make the demand for shares rise and share prices increase.

If economic conditions are difficult, markets are likely to be unstable and therefore companies profits may suffer as a result of tough market conditions.  This will make investors nervous, and demand for shares may slow and so share prices could fall.

Shares should generally be held in a portfolio where there are investments in a range of companies across different industries and even sometimes countries to provide diversification or balance.

Gilts and bonds

When you buy a gilt or bond you lend money to the issuer for a fixed period, in return for a fixed rate of interest. ‘Gilts’ are bonds issued by the UK Government while most other bonds are issued by companies. Gilts are generally considered the safest type of bond, because it is considered unlikely that the Government will default on a debt.

The end date of a bond is called its maturity date. If you still own the bond when it matures, you get back the issue price (usually £100 per bond) which would be what you paid for it if you bought it when it was first issued. The market value of gilts and bonds will change between their issue and their maturity and they can be influenced by various factors such as interest rates, inflation and exchange rates.

When interest rates go up, bond prices go down. For example, if your bond pays 6% interest and interest rates rise from 4% to 8% your bond would become less attractive as the rate of interest it is paying is less (by a half) than the interest rate you could get by putting your money in a bank account. The opposite is also true: falling rates tend to cause rising bond prices. Rising inflation is bad news for bond prices, as the income generated by a bond is a fixed amount of money, meaning bond’s buying power will decrease if inflation rises. Foreign exchange rates can also have an influence, particularly if the pound is struggling against other currencies, which may force the Bank of England to increase interest rates.

Corporate bonds or gilts can help reduce your overall portfolio risk as, compared to shares, they tend to carry a lower level of risk, though this is not always the case; some bonds are riskier than some shares. The prices of bonds tend to move more predictably – and less suddenly – than those of company shares. This means while you’re less likely to make a quick profit, with some bonds there is normally less chance that you will lose your money altogether.

Funds

Investing in a fund is different from investing directly in shares or bonds. You can find out more about funds in our Understanding Funds section.


Diversification – what does it mean?

 

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