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Know your risks, reap the rewards
By Sarah Coles
Stocks and shares ISAs can seem intimidating to anyone who hasn't dabbled in the stockmarket. This is largely because they are more complicated than cash and involve taking a risk.
Here, we take you through common types of investments, explaining what they are and how they work. Without the jargon, a good deal of their complexity melts away. The risk, however, is here to stay. But it's worth looking at it as the price of a reward that can potentially be dramatic, especially when compared with the alternatives.
Over any 10-year period, there's a 90% chance that shares will do better than money in the best savings account. If, 10 years ago, you had invested £10,000 in a savings account paying 5%, you would have made £6,470 before tax. In the average unit trust, you would have made £8,234 and, if you had invested in a consistent outperformer, such as the Fidelity Special Situations fund, you would have made £19,350 (in the 10 years to the end of 2007).
Think ahead Your time-horizon may dictate the sort of ISA you go for. If you're investing for less than five years, you would be advised to stick with cash. If you're investing for school fees or a wedding, for example, a stockmarket slide that coincided with your need for that money could be a disaster.
With an investment horizon longer than five years, however, any adviser would insist that stocks and shares were at least part of your portfolio. This is particularly the case for those who have focused on cash ISAs until now. If, for example, you had invested your full allowance in cash since 1999, you would be sitting on more than £35,000 in cash savings. At this level, you ought to be thinking about diversifying.
Also, if you simply focus on cash, you are missing out on a large proportion of your potential ISA allowance. This year you can invest £3,000 in cash and £4,000 in stocks and shares, so in the years since ISAs came along you would have wasted £36,000 of your tax-free allowance. Admittedly from April, just £3,600 of your allowance is for stocks and shares only, but you still stand to miss out if you ignore everything but cash.
So where do you go when you take your first steps beyond cash? The usual way is through a collective investment, typically a fund or trust. Here your money is pooled with that of thousands of other investors, and then invested by a fund manager.
This allows you to take advantage of their expertise and research. It also enables you to invest in numerous stocks and shares, so spreading your risk. For example, if you invested in a single company's shares, bad news that sent the share price tumbling by 20% would bring the value of your investment down by 20%. If, however, you invested through a fund, it might be one of 100 different shares held by the fund, so your overall investment may fall less than a quarter of a percent. Meanwhile, other shares in the fund would have been rising, so overall you may not see any drop.
There are broadly two types of these collective funds. The first includes unit trusts and open-ended investment companies, often just called funds. The second is investment trusts.
Investment trusts typically have lower charges as most don't have initial charges and have lower annual charges than a unit trust. The other major difference is the way they are bought and sold.
While the price of a unit trust will depend directly on the value of the investments it holds, investment trusts are a bit different. You buy into a slice of the trust, exactly like buying a share in a company. This means that the price doesn't just go up and down in line with the value of the underlying investments of the fund; it goes up and down depending on the popularity of the fund too. If lots of investors are selling out, the share price goes down, and could sell for less than the value of the underlying investments - known as a discount.
On the flipside, if they are popular, they can sell at more than the value of their investments - at a premium. As a rule of thumb investment trusts tend to rise more than unit trusts in good markets and fall more in bad ones.
First steps Whichever type of fund you pick, there are hundreds to choose from. This can seem overwhelming, but it actually helps you pick one that most closely suits your needs.
Your first steps should be into those considered relatively low risk. These include shares in large, reliable, blue-chip household names with strong businesses. Many of these pay good dividends and have a robust share price, so are considered relatively safe bets.
These funds will be in the UK All Companies sector. The fund manager may also be told to look particularly for companies that pay good dividends. These are also considered relatively low risk, because even if the share price suffers, the regular flow of dividends may keep the fund in positive territory. Funds like this will be in the UK Growth and Income sector.
Alternatively, there are funds that invest in bonds, which is another word for holding debt. It may be a company that owes you money (corporate bonds) or government debt (government bonds or gilts). In return for you lending your money, they pay you interest and promise to repay you after a specific period of time. If you hold the debt of responsible companies or governments this is considered less of a risk than holding shares, because there's a very high chance they will deliver on their promises.
Funds that hold mostly debt will be in the UK Corporate Bond sector. These are considered a good first step, usually with some of your ISA allowance in a share-based ISA and some in a bond-based ISA.
There are also property funds that they invest in commercial properties such as offices and shops. Investors have been able to hold commercial property in an ISA since 2005. Traditionally, this was considered to fall somewhere between shares and bonds, in terms of risk. Diversification into a third asset was also considered a good way to spread risk.
One caveat this year, however, is that property is going through sobering times. Until last year this otherwise steady performer rocketed through the roof. In the past 12 months, by contrast, it has seen a spectacular slump. It is pointless trying to guess, but if you have other priorities it is worth attending to them first, because the experts say such unusual behaviour makes the market less of a straightforward choice.
When you have spread your risk, with a core UK shares fund, a bond fund and commercial property, you have a good relatively cautious stocks and shares ISA holding. You may want to build this up without taking any more risk, spreading into a number of funds in each area.
Decision time Once you know the sector or sectors that suit you, the final step is to pick a fund. You will need to do a bit of research. We have listed the top performing funds in each sector over the past year. Past performance is not a guide to the future. However, looking at a fund that has done well in both the short and long term may give you some ideas for where to start your research.
When examining each fund, you are looking for a manager with a good reputation and a track record of making money in good times and bad. You also want a fund where the manager's stated objectives match yours. So, for example, you can get a corporate bond fund that invests only in the safest bonds (AAA). Or you could opt for a bond fund that invests in companies that are less likely to pay back the debt, but pay a higher interest rate and offer a higher rate in return. The factsheet of each fund will tell you what the fund mainly invests in, so you need to match the risk the fund takes with the risk you are looking for.
Another option is to consider a tracker fund. These don't attempt to beat a particular sector, but to match it exactly. They tend to have lower charges than those that aim to beat the market. They will appeal if you think the market is likely to rise in the period you're investing for, and if charges are a high priority.
Your fund research can be done direct with fund managers, telephoning the ones you are interested in and asking for a fact sheet and brochure.
Once you have selected a fund, the final step is to pick the best way to buy it. If you are struggling to make these decisions yourself, put yourself in the hands of an independent financial adviser. They will charge a fee or take a commission, but it may well be worth paying for the right decision than making the wrong one.
Otherwise, it's worth looking for a discount broker or fund supermarket. These are websites which allow you to buy a huge range of funds at lower charges. If at all possible you should avoid buying direct from the provider, as you will pay the full charge and receive no advice.
Once you have completed all these steps, you will have a good, balanced portfolio to build from.
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