Investing in ISAs need not be a risky business

WITH the inevitable tax rises on the horizon, it should be a timely reminder to all of us about the potentially significant long-term benefits of investing in an ISA.

These arrangements remain free from personal and capital gains tax, and have evolved considerably from the rather restrictive, albeit welcome, personal equity plans (PEPS) introduced by the then chancellor Nigel Lawson in 1986. The modern ISA has now become far more generous both in terms of what you can invest in, as well as the increased investment limits for this tax year, with the current annual subscription increased to 10,200.

Half of this amount can be invested in cash with the option to invest the remainder in equity-backed assets. Forgoing the option to invest in the cash element in any one year will allow you to invest the full allowance in other investment alternatives. With such a range of asset classes, there remains the question of how much risk to take.

The principles of risk assessment should remain constant when considering investments. For example, what period of time are you likely to be investing for and what is the desired objective? If your aims are long term, such as retirement or paying off the mortgage, it is important to consider what different asset "classes" can offer while taking into account any volatility.

Within the range of asset classes available, cash has been through a period where interest rates have reduced considerably. The effects of inflation have generally resulted in capital reducing in real terms – not exactly what is required for long-term objectives of real growth.

Equity investments can be volatile, as experienced over the last few years. This is a constant dilemma for most investors who try to balance risk and reward. One of the more effective methods of managing risk and securing equity exposure is through pound cost averaging.

This is achieved by investing a fixed amount of money in a particular investment vehicle (shares or fund) on a regular, usually monthly, basis. When prices are high, contributions may buy fewer shares or fund units but, when prices are low, contributions buy more shares or fund units. It is a strategy that benefits from volatile markets, provided the investments are held until the market recovers.

The continuous drip-feed method of investing results in the average purchase price paid over any given period being lower than the arithmetical average of the market price. Investment decisions are less worrying – there is no need to panic when the price falls because you will merely be buying more of your chosen investment – and, by spreading contributions over time, there should be little concern about committing investments funds at a perceived high in equity markets. In a bear (falling) market, pound cost averaging allows you to build up an investment poised to benefit from a recovery without having to worry about trying to work out when the bottom of the market will occur. However, the strategy will mean you would lose out on the best of the growth in a bull (rising) market.

There are a number of steps you can take to assess where you are in terms of reaching your long-term objectives and how much risk you are prepared to take. There is a substantial difference between understanding risk and managing it – the former should be your first objective. Above all, remember that, if you don't use your ISA allowance in any year, you will lose it forever. Use some of your allowance each year and, one day, you may be pleasantly surprised.