The previous section's examination of the risk and return characteristics of different asset classes revealed that an investor's natural desire for capital protection and investment growth are incompatible in the short term. This is because while equities provide opportunities for real and consistent capital growth, they only do this over the longer term. Over the short-term, equities do not protect capital values. So an investor can only aim to achieve high returns (capital growth) by taking high risks (short term fluctuations in capital value).

Debt instruments fluctuate less in value over time. But they do not offer the long term growth potential of equities. A ‘defensive’ investment plan using bonds and money market instruments must sacrifice the potential for higher returns.

Investors with longer term horizons may still demand bonds if there is the need for a fixed income cashflow from investments, or if the investor is psychologically risk-averse and feels uncomfortable with short-term falls in value. Debt instruments offer more stable, but lower overall returns. Income can be generated from equities - from dividend payments or from selling shares – but dividends are not guaranteed, and income from selling shares may result in fall of portfolio value. So bonds provide a certain income-stream for the more conservative investor.

To summarise:

1. Long term investors must learn to live with intermediate swings in equity value without getting too carried away by either optimism or pessimism.

2. Long term investors who cannot cope with temporary, short-term falls in value need to hold a proportion of their assets as bonds.

3. Shorter term investors must always hold a high proportion of assets as debt instruments (bonds and money market instruments) to prevent against the risk of having to recoup cash value at a time when stock markets are performing badly.

Let's see what this means in terms of an asset allocation mix.