Most investment portfolios are built from two core asset types: fixed income and variable income. These terms can sound technical, but the underlying concepts are straightforward. Fixed income means lending money in exchange for a defined return; variable income means owning a share of a business, with returns that vary with the business’s performance.

Understanding both, and how they interact, is the foundation for building a portfolio that matches your risk profile and goals.

What is fixed income?

Fixed income (also called bonds or debt securities) works like a formalised loan. When you buy a bond, you are lending money to a government or corporation. In return, the issuer promises to pay you a fixed interest rate (the coupon) at regular intervals, and to return your principal at the end of the bond’s term (the maturity date).

A UK government bond (gilt), for example, might pay 4% interest annually for 10 years, then return the original investment. The return is defined at the outset and does not depend on how the government’s finances perform beyond its ability to repay — hence “fixed.”

The main risks in fixed income are:

Credit risk (default risk): the risk that the issuer cannot repay. Government bonds of stable countries have very low credit risk; bonds from less creditworthy issuers or companies carry higher risk, and typically offer higher interest rates to compensate.

Interest rate risk: when interest rates rise, the value of existing bonds falls (because newly issued bonds offer better returns, making older bonds less attractive). When rates fall, existing bond values rise. This matters only if you sell before maturity.

Inflation risk: fixed payments become worth less in real terms if inflation rises above the coupon rate. Index-linked bonds address this by adjusting payments with inflation.

What is variable income?

Variable income (equities, or shares) means owning a fractional share of a company. As a shareholder, you participate in the company’s success and failure.

Returns come from two sources: capital appreciation (the share price rising as the company grows) and dividends (periodic distributions of company profits). Neither is guaranteed. A company can grow dramatically, providing excellent returns, or it can struggle, decline or fail entirely, providing negative returns.

The key distinction from fixed income is that there is no promise about returns. The upside is unlimited in principle; the downside is total loss of the investment if the company fails. In practice, diversification across many companies (through funds) limits downside risk significantly — no single company’s failure destroys your entire portfolio.

Historically, equities have produced higher average returns than bonds over long periods, compensating investors for accepting the higher volatility and uncertainty. This is the equity risk premium: the extra return investors demand for bearing the additional risk.

The risk-return relationship

The fundamental trade-off in finance: higher expected returns come with higher risk. This relationship is not accidental — it is structural. If a safe asset and a risky asset offered the same expected return, no one would hold the risky one. The risky one must offer a premium to attract investors.

This has practical implications:

  • Government bonds of stable countries offer low returns but low risk. They are appropriate for capital preservation and portfolio stability.
  • Corporate bonds offer somewhat higher returns, with somewhat higher risk (company creditworthiness matters).
  • Equities offer the highest long-term expected returns, with the highest short-term volatility.

The appropriate mix depends on your risk profile and time horizon, as established in the previous chapter.

How they work together

One of the most practically useful features of fixed income and equities is that they often move in opposite directions during market stress. When equity markets fall sharply — as they did in 2008, 2020 and various other episodes — investors frequently move toward the perceived safety of government bonds, pushing bond prices up (and yields down). This negative correlation means a portfolio containing both is less volatile than one containing only equities.

This is the rationale for the classic balanced portfolio — typically described as something like 60% equities and 40% bonds — which seeks to capture equity growth over time while the bond allocation dampens volatility during downturns. As an investor approaches retirement and their time horizon shortens, the bond allocation typically increases, preserving capital at the cost of some growth potential.

The diversification benefit is not unlimited and does not always hold: during some market stress events (particularly those driven by rising inflation, like 2022), both equities and bonds fell together. But historically, the negative correlation is more reliable than not.

Practical access points

For most individual investors, the practical way to access both asset classes is through funds rather than individual securities.

Bond funds (or bond ETFs) hold a diversified portfolio of bonds, providing exposure to the fixed income asset class without requiring you to select individual bonds or manage maturities.

Equity funds (mutual funds or ETFs) hold a diversified portfolio of shares. Index funds track the performance of a market index (like the FTSE All-World or S&P 500) at low cost, which is the approach recommended in the next chapter.

A balanced fund or a target-date fund holds both asset classes in a defined ratio, automatically rebalancing as the target date approaches — this can be a simple, low-maintenance approach for investors who prefer not to manage the allocation themselves.

The simplest effective portfolio for most long-term investors is a combination of a global equity index fund and a government bond index fund, held in proportions that match their risk profile and adjusted gradually as retirement approaches.