The largest single allocation in private client portfolios has traditionally been to equities. This is understandable given that according to finance theory, equities generate higher returns over the long term than less risky assets such as bonds and cash. Research by Barclays Capital shows that from 1900 to 2005, UK equities delivered an average annual total return of 9.5%. This compared to an average total return of 5.2% by UK government bonds (gilts) and 5.0% by cash while the average rate of inflation was 3.9%.

Nevertheless, in exchange for gaining a potentially higher return over the longer term, you need to accept an increased risk of losing capital, particularly over the short term. For example, in 1973 the average annual total return of UK equities was -26.6% and this was followed by -43.6% in 1974. The new classic example is the three years after the bursting of the technology bubble at the start of 2000 when the FTSE delivered negative returns in 2000, 2001 and 2002.

What are equities? Companies can raise money through the issuance of shares on a stock exchange. By buying shares in a company, you gain a stake in the business but also carry the risk of losing part or all of your investment. Shareholders are last in the queue when assets are distributed in the event of a company going out of business. This is an extreme possibility, of course, and the risk of investment losses depends on the company with which you invest.

You may receive distributions from the company in the form of dividends paid out of its profits or share buybacks. The greater the profits of the company, the more scope they have for paying dividends.

Shareholders can also achieve a return on their initial investment through an increase in the share price. The price is determined by the demand for the company’s shares. Demand is driven by factors such as cash flow, earnings growth, profits and the market outlook. There are different types of shares that you can own. Investors usually buy ordinary shares in a company, which allow them to vote on motions at its annual general meetings (AGMs) and extraordinary general meetings (EGMs). There are also non-voting shares.

Another type is the preference share. Holders of such shares are “preferred” because they rank before ordinary shareholders in gaining their share of the business. Preference dividends are paid before ordinary dividends and preference shareholders will receive their share of assets before ordinary shareholders if the company is wound up.

Preference dividends, however, are likely to be fixed and will often be repaid at a pre-determined date. It makes them more predictable and less risky than ordinary shares but it also excludes them from most of the capital growth ordinary shareholders can achieve.

Warrants usually give shareholders the right but not the obligation to buy new shares in a company at a fixed price and on a fixed date. Simplistically, evaluating whether warrants offer good value is determined by how much the shares must rise in value for the warrant investor to recover his money and make a profit.

As with all asset classes, equities cannot be regarded as a homogeneous group when viewing their risk reward characteristics. Most investors concentrate on UK equities. This is understandable given that you are more likely to invest in companies with which you are familiar. There is also no currency risk when investing in the UK for sterling investors.

Small and mid cap stocks offer the potential for delivering higher returns over the long term than large caps. This is because generally they are younger companies in a faster growth phase than large caps, which are usually mature companies. Small cap stocks are also generally less well researched than the large end of the market. This means there is potential for more mis-pricing and greater investment opportunities.