Stick your head into the stocks

Want to build up your savings, but mystified by financial jargon? A new column offers expert and basic guidance

SMALL savers who have shunned the stock market and remained faithful to building society accounts have had a distinctly smug air about them recently. Handsome bonus payments if their society is taken over or converts into a bank have added sparkle to a traditionally conservative investment. Money is safe and earns interest, and the prospect of a pounds 500 windfall has offered the possibility of better returns than from any stock market and offset falling interest rates. Why on earth even consider moving savings into stocks and shares, where you might lose money?

In fact, these savers are already shareholders in effect, even if it's as though they are in something akin to the safest of privatisations. Building societies are owned by their savers and borrowers. The windfalls are simply the crystallising or buying out of your share in the society. What the windfalls should not be seen as, however, is a reward for investing in cash. These exceptional payments are common to building societies and the other mutual organisations owned by their customers, not to savings accounts in general. As a stock market-quoted company, TSB's shareholders and savers/ borrowers are distinct, and it is the shareholders who enjoy the fruits of the Lloyds bid, not the customers.

This would seem only to argue the case for placing savings in a building society rather than a bank. But the shedding of building society status, called demutualisation, can only happen once, so after a while this bandwagon must cease rolling. And if, for some part of their savings, people are seeking a higher return than the interest on their deposit account, they will have to look elsewhere to higher- risk investments - namely to bonds or shares.

The important point to stress is that normally any increase in prospective return brings with it an increase in risk. A higher-risk investment will, on average and over a reasonable period of time, generate a higher return. But there is the chance that in any one year the capital value may decline, leaving investors with a capital loss. So investors need to take a longer-term view. The higher the risk of an investment, the longer the time horizon required.

Given that money may be required at short notice, some of your savings should always be kept in a deposit account where you can get your original money back at relatively short notice, and in the meantime that money earns interest. But with higher-risk investments it is important to sell when the time is right, rather than when a large bill comes along.

One step up from cash on the risk-return ladder are fixed-interest securities or bonds; and above them come shares, often referred to as equities or stocks. Still further up are found venture capital investments, derivatives, gambling on horse-races and playing the National Lottery. But stick to bonds and equities, both of which have produced higher long-term returns than cash.

Many have significant exposure to shares and bonds through unit trusts, investment trusts, pension funds or life policies. It is important not to confuse the packaging with the investments contained in it.

A true bond, as opposed to packaged bonds sold by building societies and life insurers, is a debt security issued by a government or company when it wants to raise money. Bonds pay a fixed rate of interest and are repayable at a fixed price on a fixed date in the future. UK government bonds are called gilts. Since gilts are issued by the Government, the risk of them not paying out is lower than with a company. Hence gilts pay a lower rate of interest than corporate bonds.

Within the corporate bond sector, the less good the credit quality, the greater the risk and the higher the interest rate paid on the bond. Since with a longer-term bond there is more chance of a company going bankrupt, bond yields usually increase with time to maturity; though when short- term interest rates are high, this is not always the case.

In the event of bankruptcy, bondholders are paid before shareholders. And although the price of a bond varies according to supply and demand, the fixed rate of interest and fixed redemption price ensure that bond returns are less volatile, and therefore less risky, than equity returns.

Shares can be issued only by companies, and normally guarantee nothing. Shareholders are the owners of a company and they receive dividends, which usually increase alongside growth in profits. But most of the return comes in the form of capital growth. As there is no fixed repayment price, share values can keep rising. So equities offer the prospect of better long-term returns than cash deposits and bonds, where in both cases returns are limited. The other side of this equation is increased risk; share prices are prone to falling faster and further than bond prices.

Despite the increased risk, for many people it is well worth considering moving some savings into equities or bonds. The current building society bonanza should be seen as a one-off, where the anomaly of depositors as shareholders is generating abnormal returns. On a longer-term view, a portfolio of equities or bonds should produce higher returns than a cash deposit, resulting in your savings being worth more.

q Jack Springman is former marketing director of Guinness Flight investment managers.