As most of your will know, Carbon is very engaged with the game of rugby through our support of the Bill McLaren Foundation and our sponsorship of London Scottish. Rugby is, in fact, a good analogy for investing, as our latest article explains.
Much of what the media focuses on when reporting on finance is the fortunes of individual companies. For an individual long-term investor, however, the danger with this approach is missing the wood for the trees.
Naturally, the media likes stories about companies because they change all the time and they often boil down to people issues. That’s fine, but what matters to you more as an investor is the performance of broad ‘asset classes’, not individual securities.
An asset class is a category of investments that shares similar characteristics and performs different functions in a diversified portfolio.
Let’s use rugby as an analogy. The forwards tend to be bigger and stronger. Their job is to gain possession of the ball and protect it when they do. The backs tend to be smaller and faster. Their job is to use the possession won by the forwards and score points.
This is a bit like the roles of bonds and stocks in a diversified portfolio. Like rugby forwards, bonds don’t tend to move very fast. They’re defensive in nature, but without them in your portfolio, you might not see much of the ball.
Shares, or equities as professionals call them, tend to be more like backs. They move around a lot more. But they also keep your wealth scoreboard ticking over.
Equities differ from bonds in another way. When you buy them, you’re becoming a part owner of the company. Whereas when you buy a bond, you’re more like a creditor; you’re lending the entity money, but you’re not an owner.
There are two types of return for equity owners. First, there is the chance that your shares will rise in value as the company grows and prospers. Second, there is the possibility of you getting a share of the profits in the form of dividends.
Bonds also have two sources of return. As with shares, if you buy in when the price is below par (its initial price), there will be capital growth if you hold it to maturity. There are also the regular interest payments you get for lending your money. This is why bonds are often referred to as ‘fixed income’.
Bonds are a more defensive investment because as a creditor, you rank ahead of shareholders in the event that the company goes bust. But that doesn’t mean there aren’t risks associated with bonds. There’s always the chance the company will default on its obligations. Plus, your fixed income may not be so valuable if interest rates rise.
The fixed income market carries varying levels of risk. Unlike shares, bonds are issued by governments as well as by companies. Government bonds, particularly the top-rated ones, are less risky than corporate bonds, but come with lower expected returns.
We can divide these categories up even further. Not every government bond is considered safe as houses. Think back a few years ago to what happened to Greek bonds during the Eurozone crisis.
Broadly speaking, equities tend to be more volatile than bonds over the long term. For that reason, the expected return for investing in shares is higher. This is called the equity premium and relates to the compensation that investors expect in return for having to put up with a bumpier ride.
But just as a rugby team composed entirely of fleet-footed backs, without forwards to defend possession, would be a risky proposition, being 100% in shares is not always wise either, unless you are very young, still building your capital and can ride out the ups and downs.
Ultimately, the right allocation to bonds and shares will depend on a range of factors, such as your age, risk appetite, life circumstances and goals. Most importantly, it comes down to what level of risk you need to take to achieve your objectives, but if the portfolio is so volatile that you can’t sleep, it may be time to review it.
Naturally, these decisions are best made in consultation with a financial professional who knows you, understands your situation and can offer a detached view – rather like the role of a referee in a rugby match. This person’s job is to ensure the game flows, the rules are followed and that no one gets hurt.
Oh, we almost overlooked the forgotten asset class: cash. It comes in the form of bank term savings accounts, with higher rates of interest, or money market funds that combine short-term loans to the government, known as Treasury Bills.
To return to our rugby analogy, you could think of cash as your reserves bench. It’s there if you need it in a hurry, though you may never call on it. The returns over the long term are less than equities and bonds, but in some years, cash can do better than one or both. Ultimately though, cash is an asset class for short-term savers rather than long-term investors.
Finally, there’s been a lot of interest recently in so-called alternative investments beyond listed stocks, bonds and cash. These include commodities, hedge funds, private equity and even collectibles like fine wine, classic cars and rare art.
These alternatives all have their own distinct characteristics, but they have disadvantages too, like a lack of transparency (you can’t see the risks clearly) or relative illiquidity (you can’t easily turn them into cash when you need it) or high fees (particularly for hedge funds).
Most advisers, like a good rugby coach, will tell you to build the bulk of your portfolio around the solid platform of stocks, bonds and cash, along with some property.
Now time for kick-off!
The value of investments and the income derived from them can fall as well as rise. You may not get back what you invest.
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