Can you risk the market?

Tessas offer modest returns compared to investment funds. But look before you leap, Paul Durman warns

INVESTORS with high ambitions for their savings can use a wide range of tax-efficient investments, but they must first ask themselves how much risk they are prepared to accept.

The importance of the relationship between risk and reward is illustrated in the table (below), which compares the performance of four kinds of investment over the past five years. The table shows the value of a pounds 3,000 investment made in January 1991 in the best- and worst-performing categories for each one.

Tessas are the talk of the investment world at the moment, as the first generation of the five-year deposit accounts starts to mature. Yet, as the table makes clear, the returns from even the best Tessas look pretty modest set alongside the results from stock market investment funds. Even investors who chose the worst-performing international general investment trust, or the worst-performing Far East unit trust, would have doubled their money over the past five years.

However, Tessas and other building society savings accounts offer investors much greater certainty. Savers can be sure their money will earn at least some return, and the range of possible outcomes is much narrower.

The risks of stock market investment are illustrated by the poor returns made by the Equitable Special Situations unit trust - and this in a period in which UK shares have enjoyed two good years. Investing in the developing economies of the Far East - fast-growing but politically and economically immature - involves even greater risks. If a serious market setback were to coincide with a need to make use of your savings, you might have been better off sticking with the dull but reliable building society.

John Cole, managing director of the independent financial advisers Berry Birch & Noble, urges investors to think carefully about their position and what they are trying to achieve before jumping to any decisions. For example, it may be unnecessary to make a five-year commitment to a Tessa if your wife or husband is a non-taxpayer who can receive gross returns from a more flexible building society account.

Similarly, most investors gain nothing from the capital gains tax exemption enjoyed by personal equity plans, since they do not make sufficient capital gains to pay tax anyway.

If you will need your money in the next two or three years -to buy a house, for instance, or to pay school fees - it would be unwise to take out a Tessa or make share-based investments such as unit or investment trusts. But if you can invest over a longer term, share-based investments will almost invariably outstrip deposit accounts.

Age is also important. A 35-year-old can afford to take a more adventurous approach to equity investments than someone who is close to retirement. That said, Sean Kingston, director of the Bristol advisers Hargreaves Lansdown, says that once in their seventies, some investors feel able to speculate again.

Investment trusts and unit trusts that invest at least half their money in UK and European Union stock markets are eligible for the maximum pounds 6,000- a-year personal equity plan allowance. PEP investments escape income and capital gains tax, and may be cashed in at any time.

Mr Cole says novice PEP investors should shun specialist funds and start by building up a holding in the broad-based UK equity income funds offered by such investment groups as M&G, Perpetual and Fidelity.

Tracker funds - which aim to match the growth of stock market indices - are another natural choice for beginners. Ken Davy, chairman of the independent advisers DBS Financial Management, favours Gartmore's UK Index fund, which tracks the All Share index. This has done significantly better than rival index funds from HSBC and Morgan Grenfell.

However, one of the greatest influences on the performance of tracker funds following the same index is the comparative charges of each fund. Both Legal & General and Fidelity now offer index-tracking PEPs with lower charges than Gartmore.

Mr Cole believes first-time equity investors should start with unit trusts rather than investment trusts. As quoted companies in their own right, investment trusts involve additional complexities.

Charles Levett-Scrivener of advisers Towry Law says another growth option is the zero dividend preference shares of investment trusts, whose value can be relied on to rise steadily until redemption, but which pay no income. Zeros can be held in a PEP, which may be beneficial for investors who incur capital gains tax.

Over longer periods, he suggests, novice investors interested in PEPs should consider the Save & Prosper Equity Income unit trust, which invests in blue-chip shares and fixed-interest securities. Towry Law also recommends the M&G Managed Growth PEP, and the GT Income and Perpetual High Income unit trusts.

However, as the table shows, some spectacular returns are made by funds that invest outside the UK. These can only accept PEP investments of up to pounds 1,500.