There is increased risk, however, with investing in small cap stocks as they are usually more vulnerable to cyclical downturns by having less capital and having a focus on fewer markets. Liquidity can also be an issue. If you want to redeem investments, particular when demand for shares is low, it can be more difficult than from large caps.

Emerging markets offer higher returns than stock exchanges in developed countries such as the UK, US, Western Europe and Japan. By their very definition, emerging markets are at an earlier stage of development, have growing populations, growing consumer markets and lower costs of production. Emerging markets also benefit from being less well researched than their developed counterparts. Therefore, over the long term, you may want to hold larger proportions of small cap and emerging market equities if you are looking for capital growth.

Emerging markets are subject to greater risks than stocks in developed markets, however. These include lower levels of transparency and corporate governance, vulnerability to cyclical downturns and political volatility. These risks, however, vary over time. 

There are a number of ways in which you or your fund managers can select equities. These include focusing on the fundamental factors of each company through analysing, for example, earnings growth, cash flow and prospects for future profits. Alternatively, fund managers may choose sectors and stocks by reviewing the macro economic outlook and deciding which companies will benefit from this environment. Typically, managers will use a mix of both of these approaches.

There are a multitude of investment approaches used by managers in analysing the fundamental factors of stocks. Managers may focus on companies that will grow faster than the average in the stock market. To gain greater value, managers may seek companies whose share price does not reflect the potential for faster than average growth. Other managers choose companies that pay a high dividend yield or whose dividend is increasing. A dividend yield is the amount of a company’s profit that is distributed as a proportion of the value of the company.

It is argued that equity income is a lower risk investment approach than focusing on growth companies. This is because if the stock market falls in value then the relatively high dividends will still provide you with an income. It is also said they instil discipline into companies’ management and reinvested dividends account for a higher proportion of total returns than capital growth over the long term. The potential downside is that these stocks may deliver lower capital growth over the long term.

Value managers try to select stocks that are inexpensive on various measures, such as trading at relatively low prices compared to their earnings. This is normally a result of the company being over-looked or out of favour. Value fund managers may seek companies that are in a turnaround situation or are in a sector that they hope will return to favour. The company turnaround may be prompted by a restructuring, new management, the launch of new products or a change in the market environment.

Within these general investment approaches fund managers have different ways of interpreting economic and company information to decide which stocks to buy and sell. 

You may choose to invest passively rather than actively. This means investing in index tracker funds or exchange traded funds. Their performance is linked directly with the underlying index. With this approach, you are not taking an active bet against the stock market. If you choose an active fund manager, you risk potentially suffering a lower return than the index. Some investors prefer to invest passively in those markets where it is relatively harder to add value through active management, such as US and UK large caps, and thus save on the active management fees.

The benefit of these different investment approaches will vary over time, depending on the economic conditions. This is because share prices are also driven by anticipated economic growth and how this will translate into rising profits and dividends. When the economy is growing strongly and confidence in future economic growth is high, investors are generally willing to pay higher multiples of profits and accept lower dividend yields than would normally be the case because they believe future growth in profits and dividends will rapidly restore these multiples and yields to normal levels.

When economic growth slows, investors become concerned about future levels of profits and dividends and may only invest if they are able to do so on the basis of below average price earnings ratios and above average dividend yields.

Stock markets, however, tend to over and under-shoot. When investors become over-optimistic, share prices generally run too far ahead of the progress of the economy. Eventually, this must be corrected by a period of stagnation in share prices while the economy catches up or by a fall in share prices.

Conversely, poor investor sentiment becomes self-fulfilling and pushes share prices down too far. Markets recover usually when least expected and sentiment has reached its lowest point. The share prices can then rise quickly over a short period of time.