FOOL'S EYE VIEW
The Stock Market Needn't Be Scary!

By Cliff D'Arcy
May 24, 2005

The world is divided into three types of people: those who save, those who invest and those that do neither.

I think of savers as people who want both their capital and their income to be safe and secure and, usually, their money ends up on deposit in a bank or building society.

Some advice on smarter saving

If you couldn't relax knowing that your money was at the mercy of the ups and downs of the stock market, then perhaps a savings account is right for you. However, if you are destined to be a saver, be a smart one: get a Best Buy high-interest account and don't pay tax on your interest.

You can do this by opening a cash mini-ISA, into which you can pay up to £3,000 per tax year. Best Buy cash ISAs pay the highest interest rates, tax free. This means a quarter (25%) more interest for basic-rate taxpayers and two-thirds (67%) more for higher-rate taxpayers. What's more, you can choose a different provider every year, if you fancy chasing the highest rates. So, if you're sixteen or over and aren't saving in a cash mini-ISA, you're missing the easiest trick of all!

Earn up to 5.2% a year tax free in our Cash Mini-ISA centre.

On the other hand, "if you can keep your head when all about you are losing theirs" (from If by Rudyard Kipling), you may find that long-term investing in the stock market is right up your street. Of course, fortunes can be made and lost through short-term trading of shares, but this game is too rich for most people's blood.

By long-term investing, I mean at least five years and, preferably, ten or more. Over this timescale, the stock market usually beats other mainstream investments, such as cash, property and bonds. The market saves its greatest rewards for the most patient investors. Investing in shares is rarely a 'get rich quick' scheme, and more often a 'go bust fast' scheme, but it does provide a slow and steady path to wealth. Here are some pointers to set you on the right path:

1. Monthly saving works

Occasionally, you read about some poor unfortunate who put all his money in at the top of the market, only to watch in horror as it went into reverse. Oops! This isn't my style; I prefer to drip-feed my money into the market as I earn it. One way to do this is to invest a fixed monthly amount into your shares or funds, and increase this monthly sum each year as your pay rises. Monthly savings plans help to smooth out the ups and downs of the market, a phenomenon that goes by the name of pound cost averaging.

What's more, monthly investing helps you to deal with falling or rising markets. I think of it like this: when the market's climbing, I know that my portfolio is gaining value. However, when the market's falling, I console myself with the thought that next month's contribution will buy an even bigger slice of the pie! Also, regular investing means that you don't have to try to time the market, which is easy to get wrong. Finally, regular investing helps encourage financial discipline, which is always a good thing!

2. Reinvest your dividends

Dividends are the income paid to shareholders, usually in the form of half-yearly payments. Not all shares pay dividends, but most big firms reward their owners with an ongoing income. Of course, you could go out and spend this money, but I'd urge you not to. If you don't need the income that your shares generate, reinvesting it in more shares is the best thing to do with it.

Indeed, roughly half of the long-run return from shares comes from reinvesting your dividends. Also, over long periods, shares that pay high dividends tend to beat the market as a whole, as this article demonstrates. So, look after your dividends carefully, as they are a large part of your stock-market reward!

3. Watch your costs

As I explained in Look Out For Hidden Charges!, the charges you pay to invest in managed funds have an enormous impact on your overall return. What's more, it's important to look beyond the headline charges, as a lot of nasty stuff can be hidden away in the small print. Indeed, the typical annual management charge of 1.5% is rarely what it seems. In fact, after adding on other less prominent administrative charges, this 1.5% can turn into a 'true' annual charge – known as the total expense ratio – of 3.22%. Scandalously misleading, isn't it?

I'm not at all convinced that it's worth coughing up hefty fees to highly paid fund managers, which explains why I've never invested in an actively managed fund. Instead, I invest cheaply in a large number of companies in two ways:

Firstly, I invest every month in a low-cost index-tracking fund. This is largely managed by a computer, so I don't have to pay for the services of an expensive fund manager. Indeed, the annual charge for my Stakeholder pension is 0.7%, which includes all administration costs, plus the cost of investing in a FTSE 100 tracker. (The FTSE 100, or 'Footsie', tracks the value of the one hundred largest companies listed on the London Stock Exchange.)

Invest in the UK's largest index-tracking fund via Fool Partner Legal & General.

Secondly, I buy iFTSE 100 shares via my self-select shares maxi-ISA. These are Exchange Traded Funds, known as ETFs, which are shares that behave much like an index tracker. Naturally, iFTSE 100 shares track the Footsie (no kidding!) and their total expense ratio amounts to just 0.4% a year. What's more, the fund is based in Dublin, so I don't have to pay the usual stamp duty of 0.5% when I buy these shares. In addition, Comdirect, my online broker, doesn't charge buying commission on iShares bought inside an ISA, which is another bonus.

iShares can be bought or sold through stockbrokers, just like any other shares, but they provide exposure to many companies at a stroke. So, they are as flexible as shares, but provide similar diversification as a fund, which means your eggs go into lots of baskets! Learn more about ETFs in A Cut-Price Way To Invest, and click on the link at the end of this sentence to see the share price of the iFTSE 100 (LSE: ISF).

Find a low-cost stockbroker in our Online Brokers centre.

4. Avoid paying tax

If your shares do well over time, you may find that you're paying more and more tax on your dividends and gains from selling shares. One way around this problem is to pop your shares into an Individual Savings Account, or ISA. An ISA isn't an investment in itself – think of it as a tax shelter or a tax-free wrapper around your shares.

You can squirrel away cash, bonds, funds or individual shares into ISAs, which fall into three groups. The annual limit for a cash mini-ISA is £3,000; for a shares mini-ISA, it is £4,000; and for a shares maxi-ISA (for serious investors, this!), the limit is £7,000. If you have a maxi-ISA, you can't have any mini-ISAs, so don't make the mistake of opening both in one tax year, or the taxman will close one down!

Don't worry about the jargon: just decide how much you can afford to put into shares each month or year, and open a mini-ISA (up to £333.33 a month) or maxi-ISA (up to £583.33 a month) accordingly. The benefits of having an ISA are marginal if you are a basic-rate taxpayer (22% rate). However, most fund companies offer ISAs at no extra charge, so it makes sense to take advantage of this opportunity. For higher-rate taxpayers, ISAs are a complete no-brainer, because they mean less tax on your dividends, and no chance of paying Capital Gains Tax for the foreseeable future!

Check out the Fool's ISA centre.

5. Picking individual shares

After you've become comfortable with investing in funds, trackers or iShares, you might fancy picking your own shares. After all, every investor dreams of beating the market year after year thanks to their own luck and judgement, don't they? However, this is a skill that can take a lifetime to perfect, so go easy. I've made and lost some huge sums from investing in individual companies, and I've had as many howlers as I've had blockbusters!

Hence, if you plan to invest in the shares of a single firm, do your own research. Alternatively, you can sign up for a free thirty-day trial of our Value Investor newsletter, and learn how our stock-picking gurus have mastered this art!

Whatever you decide to do with your savings and investment, tread carefully - and don't let them keep you awake at night!

More: Visit our Cash Mini-ISA, Index Tracker, ISA and Online Brokers centres.