COMMENT
Picking The Best Investment

By David Kuo (TMFDragon)
December 7, 2005

Have you ever agonised over whether you should invest more of your money in bonds or whether you should allocate more of your portfolio to shares? If so, you're not alone.

There are many different classes of assets (e.g. property, commodities etc) but here we'll concentrate on three basic types, namely cash, bonds and shares. Resolving how your money should be allocated between these three is not easy.

In my view, deciding which investment is best boils down to just four things. So here is my quick take on how cash, bonds and shares stack up against each other.

Risk

Without question cash is the least risky of the three. For instance, if you stashed £100 under your mattress then it should remain intact no matter how long you leave it there. Naturally, a better way to hold cash is to use a high-interest savings account or a Cash Mini ISA, because you'll earn interest. Meanwhile, bonds, which are essentially IOUs from governments or businesses, can vary considerably in risk.

In general, gilts, which are loans made to the British government, are considered to be very safe. The same cannot be said of corporate bonds though, because companies have been known to default on their loans. Finally, shares are probably the most risky of the lot. Individual companies can collapse, and share prices can fluctuate without rhyme or reason.

Returns

Closely linked to the concept of risk are returns. Over the last eighty years or so, bonds and cash have returned about the same - an annual average of around 6%. Government bonds tend to offer some of the lowest returns, and they also can fare badly when interest rates are rising. On the other hand, corporate bonds tend to perform slightly better. Over the same time frame, shares have returned around 11% per year, comfortably more than cash and bonds.

Accessibility

If you need to access your money quickly then you should almost certainly keep your investment as cash. Generally, this will mean leaving your money in a current account or an easy-access savings account.

With bonds, you agree to lend you money for a fixed term. Consequently, you should get your money back with interest after the agreed term. However, it is possible to buy and sell bonds before their term is up, although you may get back more or less than you originally invested.

As for shares, it is commonly said that you should not consider buying shares unless you plan to stay invested for at least five years. In the short term, shares can fluctuate, which means you may not always get back your initial investment if you are forced to sell at the wrong time.

Simplicity

There was a time when investors used to plump for cash because they found bonds to be quite complicated. What with face values, coupons, yields and ratings to ponder over, it's little wonder that bonds were a massive turn off. Investing in shares can be just as complicated with investors needing to familiarise themselves with an entirely new vocabulary. But today there are bond funds and index trackers that make investing in them as easy as transferring money into a savings account.

So there we have it. In my view, there is room for cash, bonds and shares in any portfolio. However, the proportion of each depends on your appetite for risk, the level of return you want, and perhaps most importantly, how quickly you need to access your money. If time is not an important consideration, then investing in shares should outperform both cash in bonds over the long term. It should also better protect your investment from the harmful effects of inflation.