PEP survey: Balancing risk and reward

Making tax savings is pointless if you lose money on the underlying investment as a result. Tony Lyons reports

Before deciding which PEP to invest in, you should make sure that you understand the risks involved. No one should buy a PEP just because of the tax advantages.

PEPs are suitable for taxpayers who have enough capital, or who can save regular amounts, which they can place at some degree of risk by investing in equities - whether directly in shares or indirectly, through a collective fund such as an investment or unit trust.

In order to make real gains, you must be prepared to invest for at least five years. According to Jane Drew of Fidelity Investments: "Investors need to understand the relationship between risk and reward in order to make sensible investment choices." In other words, the higher the potential return, the greater the risks. When it comes to equities and other high risk investments be prepared to make losses as well as gains.

The lowest-risk investments are cash and near-cash fixed interest accounts, such as those offered by the banks and building societies. More risky are bonds, then come equities, with collective investments being less of a risk than going directly into shares. This is because unit or investment trusts provide you with widely diversified portfolios.

Share prices are determined by many factors, including the health of the economy. Ultimately, if there are more buyers than sellers, prices will rise.

Most investors will be happier with a PEP that invests in a collective fund. But even here there are ways of reducing risk. All PEP brochures now show the degree of risk attached to any particular investment. Lowest of all are protected funds that guarantee you will at least get back your original capital after five or six years. These are followed by tracker funds which simply mirror the performance of a chosen stock market index, usually the FTSE 100 or FTSE All Share.

After these come more actively managed funds. Balanced UK-investing funds, along with managed funds, are generally seen as being lower risk than growth funds. On the scale of risks, then come international funds, European and US specialist funds, smaller company funds, until you get to the really high-risk end of the spectrum of the emerging markets.

Even after deciding what degree of risk you are prepared to take, it can pay to look at the volatility of a particular fund. This is a statistical device for highlighting the degree of variation in a fund's unit price from the average - "the relationship between the price movements of an investment and it's benchmark index", says Ms Drew.

The more volatile a fund, the more its unit price fluctuates. This is a statistical way of measuring how the price at any time deviates from its average price, usually over a one or three-year period. An historic guide only, a highly volatile unit price does not necessarily imply a bad investment. It just means that, at any given time, its price could vary widely from the sector average.

"We generally look at six time periods at least," says Chris Hardy of Reuters Funds, who provide statistical analysis. These measures of volatility are sometimes available in specialist magazines such as Money Management. "However, if you go back too far, it can become irrelevant," warns Mr Hardy. "Over time, many funds change or amend their investment aims. This sort of analysis is only for the professional adviser or very sophisticated investor."