How to invest in the stock market in 2006

Here's seven ways, some riskier than others, to make returns this year, says David Prosser

At around 5,700 points, the FTSE 100 index of shares in Britain's biggest companies is at its highest point for more than five years. Early new-year gains have followed a profitable year for stock market investors - share prices rose by an average of 16 per cent in 2005. Most forecasters expect more modest returns during the next 12 months. The consensus prediction from 25 investment experts last month was for the FTSE 100 to hit 6,000 by the end of 2006, a gain of around 6 per cent.

Combined with the average FTSE 100 dividend of around 2.5 per cent, investors are looking at a potential total return of about 8.5 per cent this year.

Although this is a good deal better than the 5 per cent return that you would currently get from a cash account, stock market returns come with a much greater level of risk, while savings accounts are guaranteed. For those who do decide to invest in the market, choosing the right investments is crucial. Equally, not all stock market exposure offers the same level of risk - and the most risky investment opportunities have much greater potential upside. In descending order of risk, these are the different ways to bet on a continuing stock market recovery during 2006.

SPREAD BETTING

Spread betting is the most risky way for smaller investors to speculate on the stock market, because it is possible to lose more than your starting stake.

Financial spread-betting companies, such as IG Index and Cantor Index, enable investors to gamble on the future movements of markets as a whole, or individual shares, over the short and longer term.

Cantor, for example, currently gives a spread of 5,708 to 5,714 for the value of the FTSE 100 Index at the end of March. If you think the index will be higher than that spread, you can stake a cash sum per point to back your view - say £50.

For every point above 5,714 the index is at the end of March, you make £50, so it is possible to make serious money, even on quite small market movements. But equally, if you get it wrong, for every point below 5,714 the index finishes, you have to hand over another £50, so losses can be dramatic.

In practice, the spread-betting firms offer facilities such as stop-loss triggers, but even so, this is the high octane way to bet on the stock market during 2006.

TRADED OPTIONS

Options are a type of derivative - an asset class about which many investors feel nervous. But while the traded options market is a risky way to bet on share-price movements, your losses are limited to your opening stake. The potential upside, on the other hand, is unlimited - plus options give you exposure to a much larger shareholding than your finances would normally allow, which can soup up returns.

A call option, the type of contract most suitable for smaller investors, is a right to buy a certain amount of an underlying asset on a fixed date in the future. But there is no obligation to buy, so if it's not profitable, you can allow your option to expire - all you lose is the initial investment.

The price of an option is its premium. So, for example, you can currently get an option giving the right in March to buy shares in Barclays at 650p, for a premium of 9p. For that option to prove profitable, you would need the price of Barclays shares to rise from the current level of 619p to above 659p. Miss the target and you lose your 9p, but for every penny above 659p, investors' returns are geared upwards. If Barclays shares move to 670p, for example - a gain of 8.2 per cent - each option gives a profit of 11p - a gain of 122 per cent.

Traded options can be dealt through stockbrokers with a link to the Liffe exchange ( www.liffe.com) and are available on individual shares and the FTSE 100 index. Just remember the downside risk - in the Barclays example, the shares must make an 8.2 per cent gain in two-and-a-half months for the options to have any value at all.

INDIVIDUAL SHARES

Buying individual equities is the most obvious way to bet on the stock market during 2006. But buy only one share and you put all your eggs in one basket. The good news is that building a well-diversified portfolio of individual equities is no longer prohibitively expensive for individual investors. "Share dealing commission has fallen markedly during the past five years, particularly online," says Richard Hunter, head of dealing at Hargreaves Lansdown Stockbrokers. "You should be able to deal for £10 a time, and 10 stocks, spread across different sectors of the market, which will give you decent diversification."

Share prices can fall as well as rise. But unless a company goes bust, you won't lose your entire investment. And with a portfolio of stocks, there should be winners to protect you from losing picks, though not from a collapse across the market.

Every year, The Independent asks leading City experts to give us a share tip for the following 12 months. This year's portfolio, first published 10 days ago, consists of Invensys, NeuTec Pharma, Cambridge Antibody Technology, Titanium Resources, Kingfisher, Protherics and British Airways. Note that this selection includes larger and smaller companies, and does not give a particularly wide spread of sectors.

INVESTMENT TRUSTS

Investment trusts pool the cash of many individuals under the control of a professional fund manager. The idea is to reduce the risk of stock market investment with exposure to a broad portfolio of shares selected by an expert.

But the way investment trusts are set up makes them a little more risky. Each trust is a company with a fixed number of stock market-quoted shares in issue. The price of these shares moves broadly in line with the value of the trust's underlying assets, but ultimately depends on demand and supply in the market.

Investment trust shares often trade at a discount to the value of the fund's assets. This discount can widen, even if there is no change in the value of the asset, which adds an additional risk factor. Also, investment trusts can borrow money to invest, gearing up their exposure to the market. If the trust's investments do badly, this borrowing will exaggerate the fund's losses.

On the plus side, investment-trust charges tend to be cheaper, so all other things being equal, an investment trust should outperform its unit trust equivalent. And if the manager makes good decisions, gearing and discounts can work in investors' favour.

For 2006, Nick Greenwood, of investment adviser Iimia, recommends Artemis Alpha Investment Trust. The trust invests primarily in UK stocks, but can also buy some overseas holding, as well as assets such as derivatives. Greenwood says: "This fund seeks high returns, but performance could be volatile."

AGGRESSIVE UNIT TRUST

Unit trusts offer the same pooling benefits as investment trusts, but don't allow gearing. Also, as investors buy or sell their holdings, unit trust companies issue more units or cancel them. This means there is no possibility of discounts to asset value arising.

The downside is that the majority of managers produce similar performances to the stock market as a whole each year. After taking into account the effect of high charges - expect a 5 per cent initial fee and an annual levy of 1.5 per cent - your investment follows the stock market up and down, but always lags behind its returns. Many investors question the wisdom of paying high charges for a fund that effectively just tracks the market. During the past three years, several unit trust managers have, therefore, launched aggressive or focused funds. These funds focus on a narrower portfolio of stocks - 25 is typical, compared with 70 or 80 for a traditional fund - so investors get the full benefit of the manager's best ideas.

Juliet Schooling, of independent financial adviser Chelsea Financial Services, says this is a more risky approach - if the manager's ideas are wrong, a focused portfolio will suffer more. But she expects certain areas of the stock market to outperform this year, which means a more concentrated approach could be rewarding.

As such, Schooling backs Invesco Perpetual UK Aggressive, run by Ed Burke. "As a highly concentrated 25-stock portfolio, this fund contains the manager's best ideas," she says. "Burke combines his stock-picking capabilities with a top-down economic overlay to ensure he is always in the best sectors at a given time."

UNIT TRUST

If a more aggressive approach does not appeal, at least some conventionally run unit trusts outperform the market - and their rivals - each year. Buy through a discount broker or an online fund supermarket and you can reduce the costs of getting professional investment services.

Justin Modray, of independent financial adviser Bestinvest, says 2006 could be the year to back Liontrust First Growth, a fund that has performed well in the past, but less spectacularly in recent years. "Manager Jeremy Lang's growth style has suffered during a time when value-oriented companies have taken the lead," Modray says. "With the market swinging back towards growth-oriented companies, we expect his style to work well in 2006."

Alternatively, consider a low-cost index tracker fund, where the manager replicates the performance of the market as a whole almost exactly. Fidelity's MoneyBuilder UK Index Fund tracks the All-Share Index up and down and costs just 0.1 per cent a year.

EXCHANGE TRADED FUNDS

Barclays Global Investors has pioneered ETFs in the UK, launching the iShares range. ETFs are stock market-listed shares that track the performance of a particular index. They are available on the FTSE 100, the FTSE 250 and a range of international stock market indices.

Investors buy and sell ETFs through a stockbroker, just like any other share. Aside from the costs of dealing, there are no other fees, though each ETF has the cost of tracking built into its price. At around 0.4 per cent a year, for example, the iShares FTSE 100 ETF is cheaper than most tracker funds.