How to spread your risk

It is important to remember that investing your money in a stocks and shares ISA can put your capital at risk. However you choose to invest the value of your investment and the income derived from it can go down as well as up and you may get back less than you originally invested. So, the old adage of not putting all your eggs in one basket has never rung truer than for investing your money.

If all your money was invested in just one fund over many years, it would be exposed to many risks that could cause a fall in value such as a collapse in the companies in which it invests, poor performance from the stock market index it follows, lack of growth in the part of the world in which it invests and below-par investing from the fund manager him or herself.

To reduce these risks, ideally, over time, your first stocks and shares ISA will grow to become part of a bigger investment portfolio that you build to suit your longer-term financial goals.

The golden rule for general investing is to start with safety and then – once you’ve enough financial confidence – branch out into diverse and more risky funds.  This might mean start starting with a cash ISA and then extending to a stocks and shares ISA, first dipping your toe into the UK stockmarket, perhaps with an FTSE tracker fund or UK equity income fund – funds where you’ll probably be familiar with the companies in which it invests and perhaps even use their company products.

Once you’re comfortable with this level, you can chart your own path according to your investment objectives and appetite for risk.

So, for a more conservative investor, you might then choose a UK corporate bond fund – where your cash invests in the debt of big blue-chip companies – or UK ‘growth’ fund that hunts for smaller British companies that are perhaps undervalued and likely to grow rapidly in the near future. If you then wanted to inject a bit more risk, you could branch out to include a fund investing overseas in perhaps Europe or the US.

However, if you’re happy to take a racier approach, you could start with a UK income fund before considering a succession of funds that invest in high-yield (and higher risk) bonds, in commercial property, emerging markets and commodities.

Regardless of how much risk your prepared to take, you should still aim for diversification between different asset classes (cash, equities, bonds, property and commodities) to ensure that your investment portfolio is balanced and well-placed to ride the inevitable stock market ups and downs.

How important is past performace?

It can be difficult to decide which fund to invest in because past performance is no indicator of any future trends.  A fund may have produced stellar returns over the past two years but that could be because the stock market or sector it invests in has been enjoying a bull run. If the tide turns its performance could soon look less impressive.

So rather than plumping for a fund based on recent performance alone, it’s more important to see how that fund has performed in relation to the stock market index it is linked to. For example, if a UK mid-cap fund is up 10% over the past 12 months but the FTSE 250 has risen 12%, it’s actually underperformed. However, if the fund has risen 15% then the manager has succeeded in beating the index – that is what you want. After all, what is the point in paying for a fund manager’s expertise if he or she doesn’t do a good job?

Similarly, because equities are volatile, negative returns over a discrete period aren’t necessarily anything to worry about. Again though, you need to see how a fund has performed in relation to the index and its peers. If the index has fallen 10% but the fund is only down 8%, then the manager has done well, relatively speaking.

Performance statistics to look for: For purposes of comparison, your key statistics to look for are its annual performances – so-called ‘discrete’ performance – and in particular over one, three and five years.

Ideally, you’ll want it to be in the top half of any published league of fund performers over each of those periods, or you might find its performance listed as being in a specific ‘quartile’. So imagine an investment fund sector containing 120 funds; the top 30 performers represent the top quartile, the next 30 the second quartile. Again, it’ll be an indicator of a well-managed fund if it’s in either the first or second quartile.

In our site this is also reflected by a Crown rating, provided by a data company called Financial Express. They have categorised funds based on past data into 1, 2, 3, 4 and 5 crowns. Funds with 5 crowns represent the top funds in their sector, the next are given 4 and 3 crowns and the rest are given 2 and 1 crowns.

To see how funds compare and to look closely at how they’ve performed over a number of years, you’ll need to do your homework. Have a look at the fund details sheet, where the fund manager gives you additional information on how the fund has performed over the years.

For anyone seeking to buy a new fund, such figures at least give you an indication of how they’ve done so far and will help you choose instead of picking a fund blindly.

What are the risks of investing?

Investing in a stocks and shares ISA is riskier than its cash equivalent as there’s no guarantee of a positive return. The value of your investment could fall. The nature of stock markets and their indices simply means that your money is at their mercy – you run the risk of losing out but also the chance of greater reward.

There are, of course, different levels of risk – a UK tracker that follows the FTSE 100 up and down on a daily basis but it will be less risky than a fund investing in Indian technology companies for example. However, if the Indian technology sector does well, returns from that fund could be significantly higher than those of the FTSE 100 – if it does badly though you could lose most, if not all of your money. It’s up to you to find the level of risk with which you’re comfortable.

The key thing to remember at all times is, regardless of how well a fund is performing, or how compelling the reasons for investing in it seem, if you’d be kept awake at night worrying about whether you’ve lost money don’t invest in it.

In essence, investing via a fund in companies or their debt (in a bond fund) means you’re taking a bet on their fortunes – their profitability or losses, corporate troubles, struggles with economic booms and busts, regulation and even political interference.

It’s worth knowing which companies your fund invests in as this will give you a better understanding of how risky it is. You can find information about the largest holdings on the fund factsheet.

Another factor to consider is who actually runs the fund – many funds do well for many years and then change the manager only to see its performance dip badly. This information will be in the factsheet. A good track record will be worth its weight in gold.

How do I compare the costs of investing?

Funds have two main charges: the initial charge of up to 5.5% to buy into the fund and an annual management charge (AMC) of up to 1.5% to cover administration costs and the manager’s expertise.

It’s worth pointing out that the AMC isn’t always the best way to compare a fund’s costs. Instead, take a look at what’s known as a fund’s “Total Expense Ratio”.

This is the real administrative cost of running your fund, and includes charges for auditing, legal expenses, documents for trustees, custody of shares and general administration.

Crucially, the TER actually includes the AMC, and rises to 3 per cent or more on many funds – so the lower the TER, the less you’ll have to spend on fees (and the cheaper and more efficient the fund’s cost management). In particular, the TER on a multi-manager fund tends to be higher because – naturally – the multimanager is buying lots of different funds on your behalf, and picking up higher costs that are then passed back onto you.

It’s often the case that many people won’t compare a fund’s costs, preferring to focus on its annual performance but it’s a valuable indicator of what you’re getting for your money as charges obviously eat into your overall return. If you’re paying for a fund with a high TER that only delivers poor or meagre growth at best over 12 months or a number of years, it could be time to think about switching to a different fund.