Developing an investment strategy

To make the most of your investment opportunities, allow your lifestyle and not stock market fluctuations to dictate your investment approach. Your goals are what count, so keep them firmly in mind when you make financial decisions. 

Long-term strategy 
Many investors use a consistent, long-term strategy to build a more secure financial future through steady purchases of well-diversified investments. But speculators and market timers are usually less concerned about consistency. They may switch investment philosophies on an emotional whim, sometimes treating their investments more like play money than the serious money needed for their financial future.

Most people would probably say they are investors, but the question is not so easily answered. During a bull market, it can be relatively easy to be a long-term investor. However, when the stock market really starts fluctuating, this is when an investor’s resilience can be tested – revealing many closet speculators.

Predictable cycle 
Market timers follow a fairly predictable cycle. When prices seem low relative to historical norms, they buy. When an investment’s value seems to peak, they sell.

In theory, market timing seems fairly rational, but in practice it rarely works. Even the most sophisticated investors, with years of experience and the best analytical tools, cannot predict the whims of the financial markets. What’s more, market timers are often misled by emotional factors such as greed or fear. Many end up potentially buying at the tail end of a market rally or selling in a panic at a loss.

The difficulty of timing the markets is complicated by the fact that most market rallies occur in brief spurts. Market timers waiting for the right opportunity to buy or sell risk being out of the market during these sudden market changes.

Market timing 
To benefit from market timing, you must accurately predict the future, not once, but twice. First, you must correctly determine when to sell. Second, you must accurately determine when to get back in. Because falling markets can rise steeply within days, your timing must be nearly perfect.

To avoid falling into the speculator’s trap, focus on the term ‘individual’ before making any investment decision. Your individual long-term goals and your individual financial circumstances – not the daily fluctuations of the stock market – should govern your decision.

Astute investor 
By focusing on your individual needs and sticking to your investment strategy, you could actually benefit from the stock market’s fluctuations. For example, a good long-term investment strategy generally includes investing a set amount at regular intervals.

Of course, changing your investments during a fluctuating market is not always speculating. It can be the mark of an astute investor if the reasons for your changes are consistent with your individual long-term goals.

Instead of market timing, try lifestyle timing. Look at your own investment portfolio and compare it to your long- and short-term goals.

Lifestyle change 
Do you need to withdraw money within the next year or so to begin funding your retirement or to make some other lifestyle change? If so, you might want to rebalance your portfolio to a more conservative mix of assets.

What about your long-term goals? Short-term market fluctuations will probably not significantly affect your long-term plans, and it may be wise to stick with your current strategy.

Emotional factor 
Disciplined, systematic investing does not promise a profit or protect you from a loss, but it does reduce the odds of you putting too much money into an investment when prices are high, and it also removes the emotional factor from your investment strategy.

Venture Capital Trusts

A Venture Capital Trust (VCT) is a company whose shares trade on the London stock market. A VCT aims to make money by investing in other companies. These are typically very small companies that are looking for further investment to help develop their business. The VCT often invests at an early stage in a company’s development, so it is a higher risk investment. This means that the VCTs are aimed at wealthier investors who can afford to take a long-term view and accept falls in the value of their investment.

VCTs also offer some attractive tax benefits. If you are a tax payer, you will receive a tax rebate of up to 30 per cent when investing in a VCT. The initial investment, up to a maximum of £200,000 per person per annum, attracts 30 per cent provided it is held for at least five years.

You need to be aware that this is a tax rebate and restricted to the amount of income tax you pay; tax deducted at source on dividends is not eligible. This rebate is only available when you invest in a new issue of shares in a VCT or a top-up, but it’s worth noting that if you buy VCTs on the secondary market in the same tax year these count towards the £200,000 allowance, despite the fact you don’t receive the income tax incentive.

Capital gains and dividends are also tax-free when you eventually dispose of a VCT, although there is no relief for capital losses. By buying shares in an existing VCT quoted on the stock market you become eligible for a capital gains tax exemption and benefit from tax-free dividends as they are paid. However, to obtain the 30 per cent tax relief against income tax you must buy shares in a VCT via a new subscription.

VCTs invest in unquoted business, so they are high risk and they can be illiquid, and management costs can also be high.

Enterprise Investment Schemes

Attractive tax breaks as part of a diversified investment portfolio

Enterprise Investment Schemes (EISs) are tax-efficient vehicles set up to encourage investment into small, unquoted trading companies. Following the changes announced in various Budgets, the EIS is the only tax-efficient investment offering a capital gains tax deferral. Capital gains tax on the disposal of other assets can be deferred by reinvesting the proceeds in EIS shares.

This relief is slightly different from the basic EIS relief, as there is no limit on the gain that can be reinvested in this way. However, the tax on the original gain will become payable once the EIS investment is sold. The reinvestment can take place up to three years after (or one year before) the original disposal.

The maximum that can be invested into an EIS within the tax year 2010/11 is £500,000 and the same amount can be carried back to the previous year provided the limit in the previous year was not reached. EIS shares are also exempt from capital gains tax once they have been held for three years. Investors in an EIS cannot withdraw their money before the fund has been wound up and are unlikely to find a buyer if they want to sell their stake early as there is no secondary market.

EIS funds fall into two distinct camps: those that wind up after the three years required for investments to be held to qualify (known as ‘planned exit EISs’) and those that carry on until investors agree that a wind-up makes commercial sense. For EIS funds and portfolios, the manager may not be able to invest as quickly as hoped. This may reduce the return on your investment, and the investment may lose its EIS status or tax relief may be delayed.

Investments in smaller companies will generally not be publicly traded or freely marketable and may therefore be difficult to sell. There will be a big difference between the buying price and the selling price of these investments. The price may change quickly and it may go down as well as up.

Investing in an EIS is at the top end of the risk scale, but in return you receive attractive tax breaks. As high-risk investments, EISs may only be suitable for wealthier investors as part of a diversified investment portfolio. The past performance of an EIS is not a reliable indicator of future results and you should not subscribe to an EIS unless you have taken appropriate professional advice.