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.

Collective investments

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.

Your Comments

the wife and i currently have a natwest isa a balanced fund and an extra income fund, we intially put in £3300 each in march 2005. we then pay £330 per month each,we are charged 5% per annum management fees. i know these isas carry a risk and these funds are low risk but at present these funds are approx£11000 &£10500. i know the markets have gone down recently but good growth happened up to then, i feel i am in a poor fund, or am i ? could you give me some good advice, or point me in the right direction. thank you hope to get a reply