Emma Tyrrell, Tuesday November 13, 2007

Investing in shares can offer far greater rewards than putting your money in a savings account - but you need to be aware of the risks

The idea of playing the stock market can be daunting. With the potential to make - or lose - significant sums of money, shares are not an area you should rush into blindly.

Yet the rewards on offer can easily outstrip the returns offered by savings accounts - particularly if you're investing for the long-term. While cash should be the bedrock of your investment portfolio, the comparatively low returns offered by savings accounts could see your money struggle to outpace inflation and, in real terms, fall in value.

Yet if you think you'll need to access your money within five years, not all investment vehicles will be suitable. Equities - such as shares and investment funds - have the best record of providing high returns over periods of five to 10 years or more, but their volatile price movements mean that in the short-term you could well get less back than you put in.

Protect your interests
Most people have short-term and long-term savings needs and will need a mixture of different assets to protect their interests. "It's always wise to keep some money in cash, in an easy-access savings account," suggests Anna Bowes of independent financial adviser AWD Chase de Vere. "The money should cover most expenses, as well as providing an emergency fund in case the car breaks down or you need a new boiler."

Once those funds are in place you should make sure you've paid off any outstanding loans, credit cards and overdrafts, unless you're happy switching your debt between 0% interest deals. Otherwise you could end up paying more interest on your borrowings than you earn from your investments. Once your short-term savings are sorted and your debts all paid off, you can then start thinking about the bigger picture.

Risk and reward
It's vital to understand that there is no such thing as a no-risk investment. Cash savings accounts guarantee that your capital won't fall in value, so (unless the bank or building society fails) your money will always be safe. Yet the lower the risk of any investment, the lower the return - which means that if you're a tax payer, the interest on those savings may merely be keeping pace with inflation. If you are drawing that interest out, rather than letting it build up, then your initial deposit will actually be depreciating over time.

Assets with higher potential returns such as shares are more volatile, meaning that their prices rise and fall - sometimes dramatically. But because the potential is there for them to outperform less volatile investments, their higher returns are proportionately less at risk from inflation.

Over short periods, the volatile ups and downs mean an investment in shares carries a high risk that you might get less back than you put in. Over five to 10 years or more, however, any falls are generally offset by previous or subsequent gains. Even the blackest day on the stock market appears as a blip when viewed 10 years down the line.

Reducing the risk
Buying and selling individual shares can be a lot of fun, but if you don't know what you're doing, you'll either need to pay for an expensive stockbroker or be prepared to lose a lot of money. Another potential pitfall for new investors is that they are unlikely to have the funds to afford a decent spread of investments.

"If you only have ten shares, you face the risk that if one of them turns out to be a Northern-Rock style disaster, you've lost a tenth of your money," says Anna Bowes. "To dilute the risk and get a good spread of investments you really need shares in around 40 to 50 different companies."

If you don't have the time or money to run your own portfolio, collective investment funds such as unit trusts could be the answer. Your money is pooled with that of other investors and used by a fund manager to buy (typically) 30 to 50 different investments. You can buy and sell your units at any time and the price will move up and down, reflecting the value of the investments held within.

There are hundreds of different funds to choose from - you can put your money in shares, property and fixed-interest stocks like gilts and corporate bonds. Just as it's important to spread your risk between different shares, so the addition of other assets like property and fixed-interest assets can limit the effects of general equity downturn.

A good place for the novice to start, according to Bowes, is a multi-asset fund, which invests in a spread of shares, property and fixed interest, as well as other asset types.