FOOL'S EYE VIEW
Avoid The ISA Pitfalls

By Maynard Paton (TMFMayn)
March 6, 2002

Carburton Street, London -- There's less than one month to go before the end of the tax year. And naturally enough, everybody is talking about Individual Saving Accounts. But with bucket loads of statistics and opinions being bandied about, there's plenty of scope to make an investment mistake. So how can the ordinary investor avoid drowning in the ISA quagmire? Here are some of the common traps prospective ISA investors fall into.

1) Thinking ISAs are not for you

If you're a saver, then ISAs are for you. In short, the tax-free status of an ISA will help boost your investment returns. As this article shows, the money to be made by sheltering your shares from Capital Gains Tax can be substantial.

Furthermore, many people think you need to be rich to get involved with ISAs. Not so. For instance, a cash ISA can be opened with just £1. For those savers who don't wish to venture into the stock market, up to £3,000 can be stashed away in an cash ISA every tax year. And the interest will be paid tax-free!

The Motley Fool's ISA Centre gives the full lowdown on the options available.

2) Relying on past performance

When looking at managed funds, too many people become blinded by impressive past performance figures. That's not too surprising, given every advert promoting a fund always highlights a great record. Trouble is, there are plenty of pitfalls with past performance numbers. One major problem is distinguishing investment skill from investment luck. With so many funds around, there's bound to be a few that have done well purely by chance.

Also check out the latest research from investment consultants WM Company. They say that over the last twenty years, 82% of managed funds have failed to beat the FTSE All Share Index. So avoid the mistake of buying unsustainable past performance and settle for a simple index tracker instead. As technology investors now know, past performance is not a good guide to the future.

3) Overstressing diversification

"Spread your risk" the experts say. Investors are often advised to buy several funds to diversify their geographical and sector exposure. But there quickly comes a point when diversification just isn't worth the hassle.

Take the FTSE 100. Amongst many other shares, anybody tracking this index would be investing in:

* BP (LSE: BP), which generates 77% of its revenues overseas;
* GlaxoSmithKline (LSE: GSK), which generates 48% of its revenues in the US;
* Vodafone (LSE: VOD), which generates 64% of its revenues in Continental Europe;
* HSBC (LSE: HSBA), which generates 51% of its revenues in Asia, and;
* AstraZeneca (LSE: AZN), which generates 95% of its revenues overseas.

With the FTSE 100, you'll get plenty of international exposure through a whole host of different companies. So, rather than subjectively weight your portfolio to different areas (e.g. 40% in UK blue chips, 20% in US technology stocks, 20% in Japanese smaller companies and so on) through different funds, you might as well just track the FTSE 100 or FTSE All Share. In general, the cleverer you're trying to be in picking your specialised funds, the more likely you'll come to grief. Interestingly enough, the financial industry's fascination with specialist funds probably stems from the fact that they typically have higher charges...

4) Ignoring charges

Ignore charges at your peril. They can seriously damage your wealth. Over the long-term, the difference in total costs between a fund with an initial charge of 5% and an annual management charge of 1.5%, and a fund that only levies an annual charge of 0.5%, can be substantial.

By simply using a computer to pick its shares, index trackers generally have lower charges than a managed fund. If you must go for the managed fund route, don't forget that there are plenty of ISA supermarkets and discount brokers around that can help save on your expenses.

5) Suffering 'Recent Event Syndrome'

The stock market has fallen for the past two years. That means it's a bad place to invest, right? Wrong. A common mistake for investors to make is extrapolating recent trends far into the future. If your equity ISA will help fund your retirement twenty years hence, look at how the stock market has performed over that sort of period in the past.

It certainly makes no sense to postpone any investments because you think the future is uncertain or because the market has fallen. The future is always uncertain! The market will always fall from time to time! But history has shown that bull markets always follow bear markets and recoveries always follow recessions. So deferring any payments now in order to wait for rosier times will probably mean investing at higher market levels further down the line.

Need more ISA information? Visit The Motley Fool's ISA Centre

More: What You Can Save With An ISA | Problems With Past Performance | Should You Invest In Overseas Markets? | How Low Charges Can Improve Your Investment Returns | Why You Should Still Invest