Don't let the news headlines make you scrap your ISA plans

World events and uncertainty always lead to fluctuating stock markets.

stock markets have been hit by the tragic earthquake and tsunami in Japan as investors worry about the financial impact of the disaster. The Japanese stock market fell 14 per cent in two days at the beginning of the week, reversing the whole of its gains for the year so far.

In the UK, the FTSE fell for four consecutive days as the news of the scale of the disaster became clear. For anyone contemplating opening an equity ISA before losing their tax-free allowance on 5 April, this week's worrying headlines and fluctuating markets could well prove a powerful motivator to think again about investing.

Approaching stock markets when they are reacting to world events is always going to be a little strange for the inexperienced. Anyone unaware of just how much the market is driven by uncertainty, fear and rumours is likely to be surprised by how much it can fall – or indeed rise – on the back of headline news.

But experience shows that markets quickly recover from confusion. Back in mid-January, for instance, the riots and uncertainty in North Africa and the Middle East saw the FTSE slip from around 6040 to 5870 in the space of a couple of days. Within a week it had recovered to 5970, before falling again to 5860 by the end of the month.

When Egypt's president Hosni Mubarak stepped down on 11 February the market welcomed the ending of uncertainty by climbing to a high for the year on 14 February of almost 6100. But any investors who panicked when they saw markets sliding at the end of January would have missed out on the subsequent gains.

Looking back to last April the FTSE stood at around 5840. But the Deepwater Horizon oil platform explosion in the Gulf of Mexico on 20 April had a massive impact on financial markets. As the subsequent oil spill spread and the costs of the clean-up operation multiplied, the FTSE went into virtual freefall, slumping to 5120 within a couple of weeks and hitting its lowest point of the year of around 4800 by the end of June.

But then, once the leak was sorted and some certainty returned, markets started climbing and the FTSE reached a year high by the end of October. In other words, the wild fluctuations in the six months between April and October would have had no noticeable effect on anyone who had simply kept their nerve and kept their cash invested in funds.

The same is true of the current situation. While there remains uncertainty, markets will continue to react adversely. "Global stock markets have fallen on the fear a nuclear catastrophe will happen, even though this has been highly unlikely, " points out Adrian Lowcock, senior investment adviser at Bestinvest. "This demonstrates the inability of markets to price in rare high-risk events, known as black swans."

Lowcock believes that the Japanese economy is strong enough to cope with last week's disaster. "Nuclear fallout is one of those events where fear overwhelms rational behaviour. Japan plays an important role in world trade. It is the third largest economy and a big importer and exporter. It has a strong manufacturing base which is likely to be interrupted.

"However, many Japanese companies operate overseas, there is enough slack in the system to ensure that supply of goods is not significantly interrupted, and Japanese companies are highly efficient. The country will recover and the effect on world GDP is likely to be minimal," says Lowcock.

The lesson is clear: investing in the stock market should be a long-term decision, not aimed at short-term gains. The last seven days-worth of confusion in markets will settle down and investments will return to their normal fluctuations, until the next headline news hits them once again.

If news-driven market swings make you nervous about investing in stock markets then, maybe, an equity ISA isn't for you. If that's the case, then it's still worth using your cash ISA allowance of £5,100 before 5 April. But if you think it's a shame to waste the whole £10,200 tax-free allowance you could put in an equity ISA, there are other tactics to use to reduce the risk.

"At a minimum you should invest with a five-year investment horizon, which should help you to ride out any possible short-term market dips," advises Alan Easter, director of the discount broker Willis Owen. "Second, you can diversify your investment by buying funds within your ISA rather than individual shares.

"You could diversify further by choosing a multi-manager fund, whose manager will buy funds run by other managers. The aim of this is to access the expertise of the world's best investment talent. These help to spread your investment risk."

The broker also offers a Cash Reserve fund which is a way to use your 2010-2011 ISA allowance without investing in stock markets right away. "With the situation in Japan changing by the hour investors may be put off by recent events," says Easter.

"If you don't want to lose your allowance but are unsure where to invest right now, you can invest up to the full ISA limit in a Cash Rserve fund, then decide when the time is right to invest in particular funds, either in a lump sum or by drip feeding your money into the market. The key for savers is not to lose your annual tax free allowance."

If you really are running scared of stock markets right now you could start a monthly savings plan ISA rather than putting in a lump sum. Your first monthly deposit could use up some of your current ISA allowance, with the next starting to use your 2011-2012 allowance.

"Monthly savings can also be a very effective investment strategy for ISA investors that don't want to or can't afford to part with a large sum of money in one go," says Rob Fisher of Fidelity International. Because you buy into investments gradually over time, you avoid the danger of buying at the top of the market.

Drip-feeding your savings into the stock market over a year, for instance, means you end up effectively paying the average cost of shares or funds over that year, missing any particularly bad swings. it can even be more beneficial, says Fisher.

"For example, anyone who started a monthly savings plan in 1999 when ISAs were launched would have invested £87,600, but the pot would now be worth £125,151. By comparison a lump sum investor would have a pot worth £124,404."

How have fund managers reacted to the unrest in the Middle East?

Fund managers have found it tricky to call how their portfolios should be revised to make the most of opportunities arising from the crisis, with most resorting to locking down their holdings and hoping for the best, writes Joe McGrath. The common factor for anyone looking at the market is that it is exceptionally high risk.

From an investment perspective, the situation remains delicate with all eyes on Saudi Arabia, which, has seen small local protests but no large-scale demonstrations such as those witnessed in Egypt, Libya, Iran and Tunisia. Saudi Arabia is seen as particularly significant because the country is home to over a quarter of the world's oil reserves.

The country is popular with fund managers due to the large concentration of oil and gas companies there and is seen as one of the most important in the region because of this.

Meanwhile, economic commentators say that Egypt could recover very quickly if economic reforms are constructed quickly and in the right way, but any lingering of protests in the country could act as a further barrier to growth. Despite all of this, some fund managers say there are some bargains to be had, now that there are signs of recovery in the future.

Most funds that invest in the region are not just in the areas of unrest, but in more stable countries too, such as Turkey, Qatar, Oman, Syria and UAE.

Research taken from the MENA funds survey in the April issue of "What Investment", on sale from 30 March.

Independent Partners; Do you need financial advice on your investments, pension or insurance? Book a free consultation with an independent Financial Adviser at VouchedFor.co.uk

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