'Strength lies in differences, not similarities' - Stephen Covey

Long-term readers of our views will know we’re big fans of investing in the stock market. Over the long term we think it’s the best way to grow your money.

But with the greatest potential reward comes the greatest potential risk, so we also think it’s worth considering holding other assets to provide some diversification during more turbulent periods.

People tend to view assets like cash, gold and government bonds as less risky compared to the stock market. But just how risky are they, and how could you use them to diversify?

All that glitters…

Sometimes described as the ultimate safe haven, gold has enduring appeal.

It’s said that during the reign of King Nebuchadnezzar (around 500 B.C.) an ounce of gold would buy around 350 loaves of bread. Today, the gold price is around £1,186 an ounce, and at my local artisan bakery a loaf of sourdough costs £3. So, remarkably, it’s still true today that an ounce of gold will buy around 350 loaves of bread.

For this reason I tend to view gold as a great long-term hedge against inflation – the rising cost of goods over time.

Gold is also a great hedge against the stock market. Its price is relatively uncorrelated to share prices, but, there’s still risk, as it can fall in value.

There are other issues too. While some shares will pay an income while you wait for them to deliver a capital gain, gold will not. In fact, buying physical gold bars and coins can be expensive and impractical – you’ve got to find a way to keep them safe after all.

The graph below shows the performance of gold (in £) vs the UK stock market (with income reinvested) over the last decade. Both would have made you money, but they’ve performed well at different times. As ever remember past performance isn’t a guide to what you might get in future.

Gold versus the stock market - 10 year performance

Past performance isn't a guide to the future. Source Lipper IM to 30/11/19

Cash is king?

Cash is principally designed to be a medium of exchange, allowing us to easily buy things with a currency that’s universally accepted.

Having some cash is important to cover day-to-day expenses - emergencies like a broken boiler or leaky roof. Equally cash is useful if you’re saving up for a big expense in the near term, like a new car or a wedding, as it can’t fall in value in the same way as stock market investments.

But cash generally isn’t a great store of value over the long term in the way assets like gold, shares and property can be.

The biggest enemy of cash is inflation, and we’re fortunate to have relatively low inflation in the UK currently. But that hasn’t always been the case, back in the 1970s, for example, inflation ran as high as 25%. So anyone with high levels of cash quickly saw the real value of their savings drop significantly.

While a return to these high levels of inflation is pretty unlikely, at least in the short term, this does teach us an important lesson. Namely that cash should be a home for money you’re likely to need in the next few years, but for anything long-term, investing in assets is more likely to preserve and grow your wealth.

The key challenge for many savers will be preserving the value of their cash. Interest rates are so low currently, it’s difficult to match inflation, let alone beat it. One of the best ways to achieve this is by shopping around for good rates, and spreading your cash between easy access and fixed term savings, which tend to offer better returns but you can’t usually access your cash until maturity.

Impact of inflation on the spending power of £1,000 over 20 years

The chart above shows how the spending power of £1,000 declines over time with an inflation rate of 2%, the Bank of England’s long-term target.

A bond like no other

UK government bonds, also known as gilts, have historically been viewed as one of the lowest risk investments. That’s because when you buy a gilt you’re in effect lending your money to the UK government, which has never failed to repay these types of loans since the first gilt was issued in 1694.

But that doesn’t mean that gilts are risk-free. Gilts are issued at par (100p), offer a fixed rate of interest, and are paid back in full on maturity. But in the meantime they're traded on the open market and the price will rise and fall depending on demand. This means you can sell the gilt before it matures, in which case you might get back more or less than your initial investment. It also means you can buy gilts below or above par and hold them until redemption – again you could make a profit or loss.

Bond markets have performed well over recent years, but as a bond's price rises its yield falls. Yields are now at historically low levels, which means the income on offer from gilts has reduced (and the scope for significant further gains is limited). There's also more room for yields to rise and prices to fall, so the potential for losses shouldn't be overlooked.

As I write a 10 year gilt yields about 0.65%, less than you can get on cash. So while gilts offer one of the most secure ways to invest if you happen to hold them throughout their lifetime, the income they currently offer is pretty minimal. Furthermore, with inflation at 1.5%, you are effectively getting a negative real return on your investment (inflation erodes the spending power of your money over time). So whether you choose to hold some government bonds really depends on how highly you prize the security they offer.

While you should consider the current situation in terms of yields and inflation it’s important not to become overly focused on the here and now. The investments we have suggested aren’t to be held just for today, investments should always be considered for the long term. We suggest at least five years.

Over the long term we believe bonds can still play a part in a diversified portfolio, as they'll perform better or worse than other investments, like shares, at different times.

This article isn’t personal advice or a recommendation to invest, and remember all investments can fall as well as rise in value – you could get back less than you invest. If you’re not sure an investment is right for you, please seek advice.

Next steps

If you’re looking to add gold, cash or gilts to your portfolio, here are some ways to get started.

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