2.4 Asset Classes and Their Characteristics

Every retail investment portfolio is a mix of asset classes — categories of investment that share similar risk, return and liquidity characteristics. This section sets out the five main classes, the trade-offs between them, the role of correlation in diversification, and how derivatives and leveraged products sit on top of these underlying classes.

The Five Main Asset Classes

1. Cash and near-cash

Cash includes bank and building-society deposits, money-market funds, Treasury bills and very short-dated bonds. It is the lowest-risk asset class and the most liquid. Returns are typically low and, in real terms, can be negative after inflation. UK retail cash deposits are protected by the Financial Services Compensation Scheme (FSCS) up to £120,000 per eligible depositor per authorised firm from 1 December 2025. Cash is essential for short-term needs and emergency funds, but holding too much for too long erodes purchasing power.

2. Bonds (fixed interest)

Bonds are loans paying regular interest (the coupon) and returning capital at maturity. UK government bonds are gilts; corporate bonds are issued by companies. Bond risk lies on a spectrum:

Bond prices move inversely to interest rates: when yields rise, prices fall, with longer-dated bonds more sensitive (a measure called duration).

3. Equities (shares)

Equities are ownership stakes in companies listed on the LSE or overseas exchanges. They confer voting rights and a residual claim on profits (via dividends and capital growth). Returns are unbounded on the upside and can be -100% on the downside. Equities are the main engine of long-term real return in most portfolios but are volatile in the short term. UK dividends are taxed as income, and gains above the annual £3,000 CGT exemption (2026/27) at 18% (basic-rate) or 24% (higher-rate).

4. Property

Property includes residential buy-to-let, commercial property (offices, retail, industrial) and indirect holdings via Real Estate Investment Trusts (REITs) or property funds. Property offers income (rent) and capital appreciation, but is illiquid — direct property can take months to sell, and open-ended property funds may suspend dealings in a downturn. Property returns are also cyclical and interest-rate sensitive.

5. Commodities

Commodities include industrial metals (LME), energy (Brent crude, natural gas on ICE), precious metals and soft commodities. They provide no income, only capital return, and are driven by supply, demand, geopolitics and the US dollar. Commodities can hedge inflation but are volatile and usually accessed via futures or exchange-traded commodities (ETCs).

Risk, Return and Liquidity Trade-offs

These three dimensions sit on a continuum. Higher expected return is generally the reward for accepting higher risk and/or lower liquidity.

graph LR
    A["Cash"] ---|Higher risk / higher return / lower liquidity| E["Equities, Property, Commodities"]
    style A fill:#d4f1d4
    style E fill:#f4cccc

Advisers should explain these trade-offs to clients in plain English, relating them to the client's own goals and timescale rather than abstract theory.

Correlation and Diversification

Correlation measures how two assets move together, on a scale from -1 (perfectly opposite) through 0 (uncorrelated) to +1 (perfectly aligned). The core insight of modern portfolio theory is that combining assets with low or negative correlation can reduce portfolio risk without proportionately reducing expected return. A 60/40 equity-bond portfolio historically had lower volatility than 100% equities because bonds and equities were often negatively correlated — though this relationship can break down in inflationary shocks.

Diversification is the practical application: spreading money across asset classes, geographies, sectors, issuers and time (regular investing smooths market timing). The FCA's suitability rules expect advisers to recommend suitably diversified portfolios unless there is a clear reason not to.

Derivatives and DLR Instruments

Derivatives (futures, options, swaps) are not a separate asset class but a method of taking exposure to one. A FTSE 100 future gives equity-like exposure without owning the shares. Derivatives can be used to hedge (a pension hedging its equity exposure) or to speculate.

A Daily Leveraged Return (DLR) instrument (sometimes called a daily leveraged ETP) is designed to deliver a multiple — typically 2x or 3x — of an index's daily return. They reset daily, so over longer periods compounding can produce returns very different from a simple multiple of the index — particularly in volatile, oscillating markets, where DLRs can erode capital even when the underlying is flat over the period. They are unsuitable for long-term buy-and-hold investors and are typically classified as complex investments under COBS 4.12A, requiring additional disclosures.

Matching Asset Classes to Client Needs

A suitable portfolio is built by matching asset classes to a client's:

• Capacity for loss — how much downside the client can afford without changing standard of living.
• Time horizon — short horizons favour cash and short bonds; long horizons allow equities and property.
• Liquidity needs — clients needing near-term cash should not hold illiquid property.
• Risk tolerance — the client's psychological willingness to see values fall.
• Tax position — ISAs (annual allowance £20,000 in 2026/27, frozen until April 2031) and pensions shelter returns from tax.

Key Takeaways for the Exam

• Five asset classes: cash, bonds, equities, property, commodities — each with distinct risk/return/liquidity.
• Higher expected return rewards higher risk or lower liquidity.
• Diversification across low-correlation asset classes reduces risk without proportionately reducing return.
• Derivatives and DLRs are exposures on top of underlying classes, not separate classes.
• Suitability depends on capacity for loss, horizon, liquidity needs, risk tolerance and tax position.