Weighing up the risk of a stocks and shares ISA
While a cash ISA offers the security of regular interest, with a stocks and shares ISA the value of your investment could fall as well as rise. But, there are plenty of reasons why you should consider them.
For starters, you're missing out on a significant chunk of your ISA allowance if you ignore stocks and shares. The maximum you can put into a cash ISA is £3,600 a year (2008/09), leaving the rest of your £7,200 annual allowance untouched.
Of course, you should never pick an investment purely on the grounds of its tax perks, but stocks and shares ISAs have some other benefits in their favour.
First, there's performance.
Over the longer term, investments in the stockmarket produce better returns than money placed in savings accounts. According to industry figures, £10,000 invested in the average unit trust at the beginning of 1997 would have been worth £21,859 at the end of 2006. The same amount invested in a building society account paying 5% interest would only have grown to £16,289.
Stockmarkets have their downs as well as ups, however, and you need to invest long term to ride out these bumps. As an absolute minimum you should look to invest for five years - longer if you plump for a more volatile investment. So if you need to access the money at short notice it's probably not the right investment.
You should also avoid them if you can't stomach the possibility that the value of your investment could fall. While theperformance of stockmarket investments tends to beat savings accounts over the long term, this isn't guaranteed. As a rule of thumb, if you have a long-term savings goal (five years minimum) - for example, your retirement or your child's education - at least consider stocks and shares. If you have short-term needs - for example, saving for a house deposit or a wedding - keep it in a cash ISA as you can't afford the value of your investment to drop.
How to invest in the stockmarket
While investments in the stockmarket can rise and fall, investing in it doesn't have to be a white-knuckle ride. Stocks and shares ISA investments cover a very broad risk spectrum, so you can match your ISA choice to your appetite for risk. The level of risk you take will determine how much you could potentially make or lose. At the lower end of the stockmarket risk spectrum, you could invest in UK blue chip companies. These are large, well-known companies in the FTSE 100. Volatility is relatively low so they tend to deliver stable returns.
If you're happy to take slightly more risk, then you could consider UK smaller companies. Being smaller, they have greater potential to grow, but also greater potential to deliver poor returns. Investing in overseas companies ratchets up the risk another notch. The less that's known about the country or company, the more risk it presents as an investment.
Developed stockmarkets, such as those in Europe and the US, are well-regulated and understood, so they perform in similar ways to the UK's. This may not be the case with emerging markets such as China, India and South America.
Different sectors can offer different risk profiles too. Sectors such as retailers, household goods, support services, banking and insurance are fairly stable as there's always a demand for their products and services. However, the fortunes of companies in sectors such as technology and pharmaceuticals can be much more volatile. If they come up with the latest must-have piece of electronic wizardry or develop a new drug, profits soar. If they fail to do this, or they lose out to competitors, they - and their investors - are looking at substantial losses.
As well as picking less volatile shares, another way to reduce risk is through diversification. By spreading your investment across different shares, sectors and countries you reduce the risk of losing the lot if a company goes bust.
The easiest ways for smaller investors to get exposure to a wide range of shares is through a collective investment such as a unit trust, open-ended investment company or investment trust.
These are investment vehicles that pool investors' money and place it in a wide range of stocks and shares as well as other investment vehicles such as bonds, gilts, property, cash and other funds. The number of holdings in a collective investment varies. Some of the more concentrated funds will only invest in around 25 companies.
Others (for example, global funds) can have more than 200. Each fund is classified according to itsinvestment objectives. As well as sectors for everything from cautious managed funds to technology and telecommunications funds, you can invest according to your ethical or environmental beliefs.
Stocks and shares ISA
Investments needn't be restricted to shares either and many collective funds invest in fixed-interest vehicles such as corporate bonds and gilts. As you are effectively investing in loans made to companies, these are a lower-risk investment than shares. The degree of risk will be determined by the grade of the bond, ranging from investment grade bonds (rated BBB- and above) to junk bonds, where the risk of default is greater.
Gilts, which are issued by the Government, are the safest of the lot, because they're the least likely to default on the loan. Additionally, because they are loans you will receive a regular income from them, which could be useful if you are using an ISA to supplement retirement income, for example.
Property is also covered by the stocks and shares element, as ISA investors have been able to invest in commercial property funds since the end of 2005. Offering more risk than bonds but less than shares, property also allows you to diversify your portfolio into another asset class.
Whatever the underlying assets, with most collective investments, a fund manager or managers will take all the decisions about where the money is invested. As well as their own knowledge, many fund managers also have access to extensive research that is not commonly available. This means you should benefit from their experience and expertise.
Some funds, known as trackers, prefer to use what is known as passive management. This is where the holdings replicate an index such as the FTSE 100 or FTSE All Share. By doing this, performance should mirror the performance of the index.
Charges vary greatly. Most unit trusts and open-ended investment companies have an initial charge and an annual charge. Initial charges range from 0% on some tracker funds through to 6% for some of the more specialist managed funds. Annual charges tend to be between 1% and 1.5%. Investment trusts have lower charges. Most don't have initial charges but, as they are listed on the stockmarket you will pay a stockbroker's dealing charge to buy and sell, as well as stamp duty of 0.5% when you buy. On top of this, you'll pay an annual charge of 0.5% or more.
Another pricing factor can also come into play with investment trusts. Because there's a fixed number of investment trust shares in issue, the laws of supply and demand can also affect the price in the shape of a discount or premium. When demand is high, shares in an investment trust can trade at a premium. This means you'll pay more for the share than the value of the underlying assets. Conversely, if demand is low, the shares will trade at a discount. As demand can change this is another factor that can affect the value of your investment.
Unlike unit trusts or OEICs, investment trusts are also able to borrow to invest because they trade as companies and are subject to different regulations. This can be a good thing or a bad thing, depending on how they perform - if they perform well your gains will be magnified, but if they perform badly, so will your losses. As a result, they are usually considered higher-risk than other collective investments.
Whichever type of collective investment you choose, with minimum investments as low as £10 a month, and most available as ISAs, you can gain access to a diversified portfolio with a much lower investment than if you had done it yourself.
How to buy your ISA
With a couple of thousand different collective investments to choose from, it's wise to do some homework before deciding where to invest your money.
The way you buy your ISA could also give you access to further information and advice. Probably the worst way to buy is direct from the fund management group. Not only will you only get information about the group's funds but you'll also pay the full charges on the investment.
You can also buy through an independent financial adviser, many of which will use fund supermarkets to pass on lower charges and flexibility.
They will also be able to offer you ISA advice based on your existing investments, objectives and appetite for risk.
Additionally, if you buy through an IFA, fund supermarket or discount broker you will also receive information from them about what's hot in the ISA market.
Details of independent financial advisers in your area who can provide ISA advice can be obtained from a number of organisations including IFA Promotion (0800 085 3050) and the Institute of Financial Planning.
Open-ended investment companies are hybrid investment funds that have some of the features of an investment trust and some of a unit trust. Like an investment trust, an Oeic issues shares but, unlike an investment trust which has a fixed number of shares in issue, like a unit trust, the fund manager of an Oeic can create and redeem (buy back and cancel) shares subject to demand, so new shares are created for investors who want to buy and the Oeic buys back shares from investors who want to sell. Also, Oeic pricing is easier to understand than unit trusts as Oeics only have one price to buy or sell (unit trusts have one price to buy the unit and another lower price when selling it back to the fund).
Investment trusts are companies that invest money in other companies and whose shares are listed on the London Stock Exchange. As with unit trusts, private investors buying shares in an investment trust are buying into a diversified portfolio of assets (to reduce risk), which is managed by a professional fund manager. Investment trusts differ from unit trusts in two important ways: they are listed on the stockmarket and so are owned by their shareholders and are closed-ended funds with a finite number of shares in issue. This means the share price of investment trusts might not reflect the true value of the assets in the company (known as the net asset value, or NAV) and if the NAV value of a share is £1 and the share price in the market is 90p, the trust is said to be running a discount of 10% to NAV. But this means the investor is paying 90p to gain exposure to £1 of assets. Investment trusts can also borrow money and use this money to buy investments. This is known as gearing and a geared trust is thought to be more of an investment risk than an ungeared one.
A hugely unpopular tax paid on property and share purchases. Stamp duty on property is levied at 1% for purchases over £125,000 (£250,000 for first-time buyers) which then moves up at a tiered rate. For property between £125k and £250k you pay 1%, then 3% from £250k up to £500k and then 4% from £500k to £1m and then 5% for properties over £1m. But unlike income tax, which is “tiered” and different rates kick in at different levels, stamp duty is a “slab” tax where you pay the rate on the whole purchase price of the property. On shares, stamp duty is charged at a flat rate of 0.5% on all share purchases. Figures correct as of May 2011.
Also known as index funds, tracker funds replicate the performance of a stockmarket index (such as the FTSE All Share Index) so they go up when the index goes up and down when it goes down. They can never return more than the index they track, but nor will they lose more than the index. Also, with no fund manager or expansive research and analysis to pay, tracker funds benefit from having lower charges than actively managed funds, with no initial charge and an annual charge of 0.5%.
A collective investment vehicle (known in the US as a “mutual” or “pooled” fund) and similar to an Oeic and investment trust in that it manages financial securities on behalf of small investors who, by investing, pool their resources giving combined benefits of diversification and economies of scale. Investors buy “units” in the fund that have a proportional exposure to all the assets in the fund, and are bought and sold from the fund manager. The price of units is determined by the value of the assets in the fund and will rise or fall in line with the value of those assets. Like Oeics (but unlike investment trusts) unit trusts and are “open ended” funds, meaning that the size of each fund can vary according to supply and demand of the units form investors. Unit trusts have two prices; the higher “offer” price you pay to invest and the “bid” price, which is the lower price you receive when you sell. The difference between the two prices is commonly known as the bid/offer spread.
There are limits to how much you can invest in any tax year. For 2011/12, the limit is £10,680. Of that, the maximum you can invest in cash is £5,340 and the balance of £5,340 can be invested in shares (individual company shares or investment funds). If you don’t take the cash ISA allowance, you can invest up to £10,680 into a stocks and shares ISA.
A financial adviser who is not tied to any financial services company (such as a bank or insurance company) and is authorised by the Financial Services Authority (FSA). They can advise on financial products to suit your circumstances. All IFAs have to give consumers the choice of paying by fees or commission and have to explain which would best suit the customer in that particular instance. Also, if commission is paid either by the client or the financial service provider recommended by the IFA, the IFA must disclose what that commission is.
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.
This is a mutual organisation owned by its members and not by shareholders. These societies offer a range of financial services but have historically concentrated on taking deposits from savers and lending the money to borrowers as mortgages, hence the name. In the mid-1990s many societies “demutualised” and became banks. One academic study (Heffernan, 2003) found demutualised societies’ pricing on deposits and mortgages was more favourable to shareholders than to customers, with the remaining mutual building societies offering consistently better rates. In 1900, there were 2,286 building societies in the UK; in 2011, there are just 51.
A market-weighted index of the 100 biggest companies by market capitalisation listed on the London Stock Exchange. It is often referred to as “The Footsie”. The index began on 3 January 1984 with a base level of 1000; the highest value reached to date is 6950.6, on 30 December 1999. The index is “weighted” by how the movements of each of the 100 constituents affect the index, so larger companies make more of a difference to the index than smaller ones. To ensure it is a true and accurate representation of the most highly capitalised companies in the UK, just like football’s Premier League, every three months the FTSE 100 “relegates” the bottom three companies in the 100 whose market capitalisation has fallen and “promotes” to the index the three companies whose market capitalisation has grown sufficiently to warrant inclusion. Around 80% of the companies listed on the London Stock Exchange are included in the FTSE 100.
An individual employed by an institution to manage an investment fund (unit trust, investment trust, pension fund or hedge fund) to meet pre-determined objectives (usually to generate capital growth or maximise income) in prescribed geographic areas or investment sectors (such as UK smaller companies, technology or commodities). The manager also carries the responsibility for general fund supervision, as well as monitoring the daily trading activity and also developing investment strategies to manage the risk profile of the fund.
Named after a high value gambling chip, the term is used for an investment seen as solid and whose share price is not volatile. Blue chip companies are normally household names and have consistent records of growth, dividend payments, stable management and substantial assets and are the bedrock of a pension fund’s portfolio.
The familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.