This is the first in a series of articles focused on the fundamentals of investing. Don’t worry if you are relatively new to investing because the series starts at the very beginning and explains what investing is, how it works and is intended to provide a useful framework for thinking about investing.

The series is not exclusively for beginners and later on it will include more advanced features such as how to analyse company results in under five minutes and the difference between ROE (return on equity) and ROIC (return on invested capital).

This article explores the types of investments available and how they differ in terms of return potential and riskiness.

First, it is important to emphasise investing is a long-term endeavour. Whether investing for a child’s school or university fees or your own retirement, the timeframe should be more than five years and ideally more than 20 years.

There are good reasons why investing works better over longer time-frames and future articles will touch upon the key ideas and benefits of developing a long-term mindset.

WHAT IS INVESTING AND WHAT CAN I INVEST IN?

Investing involves laying out cash today and therefore delaying consumption in return for receiving a larger sum of money in the future.

The more time investments are given to earn a return, the greater the potential rewards.

The investment landscape can appear overwhelming at first, because there are thousands of investment products available. Therefore it’s useful to break the investment universe down into three core components consisting of cash, bonds and equities (also referred to as stocks and shares).

Cash is the safest investment choice but provides the least attractive return potential while shares are the riskiest but offer higher rates of return, and bonds - which are a type of I.O.U issued by governments and companies - are somewhere in the middle.

How much cash an investor puts into each of the three investment types will depend on their individual risk appetite, age and personal financial circumstances.

In general, younger investors and those willing to take greater investment risk may be comfortable investing a bigger proportion in stocks. Older, more conservative individuals may feel more comfortable with a bigger proportion invested in relatively safe bonds and cash.

DIVERSIFICATION

One of the most important ideas in investing is diversification, which means spreading investments broadly rather than putting all your eggs in the same basket. Academics have described the benefits of diversification as the only ‘free lunch’ in investing.

It is better to think about investments as a portfolio or group of companies rather than individual companies. A well-diversified and balanced portfolio will be more resilient to swings in share prices and provide a smoother return.

Diversification is achieved by spreading investments across several industries and sectors, different sizes of companies, and overseas markets.

Exchange traded funds or ETFs provide ready-made diversification and are good vehicles for efficiently tracking major indices. Investors starting out should consider index ETFs as a fast and easy way to achieve a diversified portfolio.

For example, the iShares Core MSCI World ETF (SWDA) provides investors with exposure to nearly 1,500 companies across 23 developed countries for an annual charge of 0.2% or just £2 for every £1,000 you invest.

The $74 billion fund is managed by BlackRock, one of the world’s largest asset managers, and tracks the MSCI World Index which is the most widely-followed global benchmark.

Similar products track global bond markets. Investing in individual bonds requires specialist knowledge and an understanding of how they work which means for most retail investors the fund route is not only more convenient but safer for non-experts.

The iShares Core Global Aggregate Bond Index ETF (AGBP) seeks to track the Bloomberg Global Aggregate Bond Index, which is composed of global investment grade bonds, and has an annual charge of 0.1% or £1 for every £1,000 invested.

Once a broad exposure has been achieved an investor can consider adding individual stocks and actively-managed funds. These decisions require research as well as a certain amount of skill and judgement. Consequently, they also add more risk to a portfolio.

There are many investment platforms aimed at the retail investor which give access to the stock and bond markets and provide tools to help with investing and managing a portfolio.

It is worth considering investing through tax-efficient wrappers such as ISAs (individual savings accounts) and SIPPs (self-invested personal pensions) before investing in other types of account because capital gains are free of tax.

In the current tax year an individual can invest up to £20,000 in a single ISA or split the allowance across multiple accounts.

WHAT ARE SHARES AND BONDS?

A share is a unit of ownership in a company which gives the owner a financial interest in a company’s future profits and dividends. Multiplying the total shares outstanding by the share price gives the market capitalisation of the company.

For example, drinks company Diageo (DGE) has roughly 2.26 billion shares outstanding and at the current price of £27.46, its market capitalisation is £62 billion.

Market capitalisation is the stock market’s best guess of the value of a company. In effect, a shareholder has an economic interest in future profit and dividends. Over the long-term share prices tend to follow profits.

Therefore, owning shares is based on a presumption that a company will grow profits and dividends over time. However, it is worth adding firms can and do go out of business from time to time which means in extreme circumstances a company’s share price could go to zero.

Alongside the high volatility of share prices, this is the biggest risk to share ownership and a good reason to diversify as discussed earlier.

A bond is a type of I.O.U. issued by governments and companies in return for a fixed payment called a coupon, which is paid over a fixed term. This explains why bonds are also referred to as fixed-income investments.

Generally, bonds are purchased for steady income rather than capital gains. They are issued at par or 100 and redeemed at par as well. During the life of a bond the price can move up and down as it does with shares and therefore capital gains or losses can be made, but if you hold a bond to maturity there is no capital gain or loss.

Bond prices tend to be less volatile than share prices, and bond income is more secure than dividend income because it is contractual unlike a dividend which is discretionary.

The main risk with bonds is the capital might not be paid back in full at maturity. Governments have the power to raise taxes, which means their bonds are safer than corporate bonds.