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Equities and Bonds

Most investors own these assets through various contracts or policies, such as pensions, ISA's etc., in what are commonly known as pooled investments.

A pooled or collective investment is one where a number of investors put different amounts of money into a fund managed by a professional investment manager.

The main benefits of pooled investments are:

  • Professional expertise - you arrange for an investment expert to pick investments for you, to watch those investments daily and judge when to sell them.
  • Spreading your risk - even if you have small amounts to invest, you can spread your money across a wide range of investments. You reduce the impact on your investment if, say, one company performs badly. Pooled investments will invest in one or more asset class.
  • Reduced dealing costs - if you want to buy a range of different investments directly, you would probably only be able to invest a small sum in each. This means dealing costs could eat into your profits significantly. By pooling your money, you make savings because of bulk buying.
  • Less administration - the fund manager handles the buying, selling and collecting of dividends and income for you. They also deal with foreign stock exchanges and brokers, which can be tricky and time consuming.
  • Choice - there is a very wide choice of funds so that you can pick one - or many - that suit you individually.

Most pooled investment funds are 'actively' managed which means that the fund manager researches the market before making decisions to buy and sell assets.

Tracker funds are 'passively' managed, which means that they aim to track a given indices. For example, a FTSE100 tracker would aim to replicate the movement of the FTSE100 (the index of the largest 100 UK companies). The return is rarely identical to the index, in particular because charges and proportionate holdings will skew the returns.

Shares

Share ownership allows you to benefit from the growth of a company.

Annual profits are normally reinvested in the business, perhaps by investing in better technology, which enables it to cut costs and, therefore, make a bigger profit the following year.

If it can continue to improve its profits, demand for its shares will grow and the share price will rise. This type of company, known as a growth stock, is popular with investors who do not need income from their investments.

Secondly, the company may pay a dividend, which is a share of the profits paid to the shareholders. Shares that pay dividends are generally known as 'Income' stocks. Companies can return money to shareholders in other ways too such as buying back their shares. This increases the value of those shares still in circulation.

By investing in shares, you are also linking your financial wealth to the health of the UK and overseas economies.

The fact economies spend longer in a growth period than in recession has helped shares produce better returns than other assets and, crucially, beat the effects of inflation.

Bonds

Bonds are effectively IOUs.

You lend a company or government money for a set period in return for a fixed income, known as the coupon. This set income means bonds are often called 'fixed interest' investments. When the bond matures, you should get your original investment back.

Bonds are not designed to produce capital growth, although they can generate a little, so these investments are not normally suited to investors seeking high returns. However, they can provide investors with greater protection than shares as bondholders are above shareholders in the pecking order if the company goes bust.

This gives them great value as 'safe haven' investments during economic downturns and the income they pay makes them very attractive to people looking for income from their investments.

How bonds work in practice

Very few investors hold bonds until maturity and instead trade them like shares. Although they have, a fixed price when they are issued demand from investors can push the price above and below this level. This effectively increases or decreases the income you earn.

What influences bond prices

Bond prices are influenced by the yield they pay and the rate of interest investors can earn elsewhere. If interest rates are high, savings accounts will pay more and bonds, therefore, become less attractive.

This does not mean it is easy to decide when to buy and sell. Bonds are traded by professional investors who try to second-guess future demand for bonds by monitoring economic conditions and anticipating interest rises and falls.

This makes them a good barometer of what experts think will happen to the economy. If bond prices rise, experts believe economic conditions are deteriorating and if they fall, it usually means the economy is improving.

Bond prices are also influenced by the strength of the individual company - if the company is weak, it is more likely to default on its interest payments. The strength of companies issuing bonds is monitored by agencies and they give bonds ratings with AAA being the highest and C being the lowest. If a company's rating changes, it will usually have an impact on its bond price.

Different types of bonds

There are a number of different types of bonds and demand for each type is different depending on market conditions.

Many bonds are issued by governments and are known as 'sovereign' debt. These bonds are usually rated more highly than bonds issued by companies. This is simply because governments are less likely to default on their debt than companies, although this may not be the case with some emerging markets.

Government bonds are often given different names - UK government bonds are known as 'Gilts', German government bonds are called 'Bunds', while US government bonds are known as 'Treasuries'.

Governments also issue index-linked stocks. Instead of paying a fixed income like most bonds, index-linked stocks pay an income that rises in line with inflation. The maturity value is also increased in the same way. This means that investors' capital is protected against the ravages of inflation and makes the bonds very attractive when inflation is expected to rise.

Corporate bonds are issued by companies but they are split into different types depending on the credit rating they achieve. Companies that have high ratings are known as investment grade bonds while companies with low ratings are known as high yield bonds because they have to promise higher income payouts to attract investors. Companies that do not achieve ratings are known as 'junk' bonds.

Companies also issue different types of bonds. Debenture stocks, for example, are secured against specific company assets while unsecured loan stocks pay higher yields but are not secured against the company's assets. Companies also issue convertible bonds that give holders the right to convert them into shares under certain circumstances.