Investing in the Stock Market: It's all a question of timing

If you're prepared to take some risk, the returns can be excellent. Here, and on pages 12 and 13, we explain how it can be done

Stock market investment is not for the faint hearted. There is always risk involved.

But with the right planning and know-how, money invested in shares can produce a vital nest egg. And over most 10-year periods since 1945 shares have outperformed other forms of savings.

When you buy equities (the technical name for ordinary shares) you are buying a share in the ownership of a company. You are entitled to some of the profits and have a vote on major decisions. Returns from shares can vary and you may lose everything if a company folds. But unlike bank and building society savings accounts or other fixed-interest investments, shares do offer some protection from inflation.

When inflation is higher than the rate of interest paid, your savings are shrinking as you hold on to them. And over the past 40 years or so, savings in deposits have lagged behind inflation.

For example, pounds 100 invested in an average investment trust 10 years ago would be worth around pounds 300 today. The same amount invested in a building society account would only be worth around pounds 180.

Shareholders receive their share of the company profits as dividends. These are usually paid twice a year and can be reinvested. The income will increase over the years as company profits rise. Investors also hope to make a capital gain. If the company's prospects improve, the share price will rise. But the success of your investment depends on when you buy and sell shares, and even experts admit it is impossible to say when the right moment is to buy and sell.

Given that the market rises and falls, an obvious method of trying to beat it is to hold shares when the market is rising, known as a bull market, and to sell shares and hold a safe investment such as cash when it is falling (a bear market).

Before investing you need to consider the profitability of that company and its prospects. You should also consider the outlook for the sector in which it operates. For example, if the oil sector is depressed because of a glut in oil supply then you may do better investing in another area.

"There are three key things that affect the stock market," explains Richard Urwin, head of economic research at Gartmore. "First, if profits are unexpectedly strong, equity markets are likely to perform well. Second, if interest rates are going up, this is bad news for equities because people will put their money elsewhere. And third, uncertainty increases risk, which means that equities are less likely to perform well."

Five years is the generally quoted minimum period, but you may do better opting for a portfolio of extremely long-term share purchases, spread around a number of companies in different industries.

You can limit your risk by buying shares in blue-chip companies. These are large, well- established companies, such as ICI and BP, which tend to have a solid reputation. But these are not cheap so if you only have a small amount to invest you won't get a large shareholding.

If you don't have enough money to be able to spread your investment and are not attracted to the risks of direct investment in shares, you can pool your money with that of other investors and spread your risk. There are three ways of doing this: investment trusts, unit trusts and Oeics (see box on the left).

And the longer you leave your money invested, the more it will grow because of the effects of compounding. For example, if you invest pounds 10,000 and interest is paid at 5 per cent every year, you will receive pounds 500.

After five years you will have pounds 12,000. But if the interest was compounded, the value of the fund would be pounds 12,762. And if you reinvest your dividends rather than take them as income, then this helps the compound growth as well.

COLLECTIVE INVESTMENTS

n Investment trusts - These hold a number of different types of investments in a range of industries and countries. They are public limited companies floated on the stock exchange. Investment trusts are known as closed-ended funds. This means that the number of shares in the fund is fixed. As share prices fluctuate, investment trust shares can be bought and sold at above or below the value of the investment trust fund.

n Unit trusts - A unit trust is a pooled fund of investors' money that is used to buy shares in companies. The fund is split into equal units and managed by a fund manager. All unit holders are entitled to a share of the assets of the trust. A unit trust is an open-ended investment.This means that the number and price of the units is set by the fund manager and affected by demand. If there is a big demand for units more are created and the fund gets bigger. If demand falls the fund gets smaller.

n Open-ended investment companies (Oeics) - These funds are similar to investment trusts and unit trusts. An Oeic is a quoted company but it can issue or cancel new shares like a unit trust.