Diversification

Spreading the risk to acquire a good mix of assets

Spreading risk and getting a good mix of assets is often known as “diversification.” You can invest directly by buying shares and bonds in different companies. You can also use funds known as collective investments, which pool your money with that of other investors and typically invest across a range of assets.

Direct investment in shares
The first thing to consider is whether you are happy to have someone else managing your money or whether you want to have sole control over where it is invested. If you want to take control yourself, you could build up a “portfolio” of shares and bonds in different companies across different sectors.

Building a portfolio of individual shares in this way can be expensive, particularly if you are investing relatively modest sums or if you want to invest outside the UK. The research and dealing can be time consuming. In general, this is something that only experienced investors should tackle.

For these reasons, many investors choose to invest in the stock market by pooling their money with that of other investors in one or more funds.

The main types of fund or pooled investments are as follows:

Investment Funds:
Authorised Unit Trusts and OEICs
Authorised unit trusts and OEICs (Open Ended Investment Companies) are investment funds which “pool” your money with that of other investors.  They invest in bulk in a selection of shares, bonds, properties, derivatives* and cash and are managed by professional fund managers dedicated to investing and administering your money.

While technically speaking the structures of the two types of fund are different, from an investor’s perspective they are the same.

You can generally buy or sell your investment through a fund manager on any working day and the daily price of your “units” or “shares” reflects the value of the assets in which the fund has invested. This is because the total number of units or shares issued by the fund increases when the fund is in demand and decreases when more investors are cashing in.

Funds which are marketed to the public must be authorised by a regulator and are subject to detailed rules designed to provide a high level of investor protection. The assets are held by an independent authorised firm, known as a trustee or a depository, which oversees the way that a fund is run. Most funds available in the UK are authorised by the independent regulator, the Financial Services Authority and are covered by the Financial Services Compensation Scheme. Some funds however, are authorised elsewhere in the European Union, such as in Dublin or Luxembourg.

* A collective term for financial instruments whose prices are based on the prices of other (underlying) investments. They are more complex investment tools than those described and are used by fund managers to help them meet their performance objectives.
Investment trusts

Investment trusts also pool investors’ money. Like investment funds they are professionally managed and diversify your risk by investing in a wide range of companies, but they have some additional characteristics. The main difference is that the price or market value of shares held in an investment trust may not be the same as the value of the investment trust’s assets.

This is because there are a fixed number of investment trust shares available to investors at any one time. Shares in an investment trust company are bought and sold on the stock market, just like other companies’ shares. If an investment trust’s shares are in demand, its price rises to a “premium,” i.e. the price will be higher than the value of the investment trust company’s underlying assets.  If there are more sellers than buyers however, the price can fall to a “discount” when the price will be lower than the value of the underlying assets.

Insurance-Based Products
There are insurance products which give you access to professionally managed pooled investments.  They may be “unit linked,” which share many of the characteristics of investment funds. They are not subject to the same regulations as investment funds, but may follow many of them in practice.

Another form is a “with profits” product, which seeks to provide a steady return by smoothing out the ups and downs of the stock market.

Tax Efficient Investing
You can save in investment funds, investment trusts and insurance products, and receive an extra tax benefit if you invest through a tax “wrapper” such as an Individual Savings Account (ISA) or a pension.

To clarify the relationship between the wrapper and the investment, imagine that the assets e.g. shares, are the ingredients, the product, the investment fund or investment trust, is the cake, and the ISA or the pension is the wrapper or box around the product which protects it from paying certain taxes.

Individual Savings Accounts (ISAs)
ISA stands for Individual Savings Account. This is effectively a tax wrapper within which you can hold a range of different investments. The big advantage of ISAs is that returns are tax-efficient (since April 2004 the ten per cent tax credit on UK dividends cannot be reclaimed), which means you are not subject to most income tax and all capital gains tax on the proceeds.

You can currently invest up to £7,200 (2008/09) in a single tax year. The tax year runs from April 6 to April 5 and your annual allowance cannot be rolled into the next financial year, if you do not use it within that time.

Maxi and mini ISAs have now been abolished. Existing mini cash, tessa-only ISAs and the cash component of maxi ISAs have been re-classed as cash ISAs. In the same way, mini stocks and shares ISAs and the stocks and shares component of maxi ISA have been re-classified as stocks and shares ISAs. Personal equity plans (Peps) have also become stocks and shares ISAs.

You can open one cash ISA and one stocks and shares ISA each tax year. Up to £3,600 can be invested in a cash ISA. The remainder of your £7,200 (2008/09) allowance can be invested in a stocks and shares ISA. You do not have to put any money in a cash ISA: instead the full £7,200 can be invested in a stocks and shares account.

Various non-cash assets can be held within a stocks and shares ISA. These include unit trusts, open ended investment companies, investment trusts, exchange traded funds, shares or bonds.

As a result of the rule changes, savers who initially invested in a cash ISA can transfer that money into a stocks and shares account. However, you cannot move from equities into cash.

Child Trust Funds
The Child Trust Fund (CTF) is a tax free way of saving for children.  Every eligible child receives a voucher worth at least £250 to invest in a CTF.

Pensions
The government provides tax incentives to encourage you to put money aside for your retirement. You or your employer can get back tax, within certain limits, when you contribute to a pension scheme.

Employer run pension schemes
It may be that you are part of a pension scheme which is run by your employer. If so, the money will be managed by professionals who may invest in investment funds and/or directly in cash, bonds, equities and other assets.

Personal pensions
If you are not part of a company scheme, you may want to set up your own personal pension.  These schemes will offer a limited number of funds. A SIPP (Self-invested Personal Pension) is a type of pension, which offers you complete control over your assets.

You choose where to invest your money and you have an unlimited choice of assets and funds. There are restrictions on when and how you can withdraw money once it is in a pension fund.