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Updated 18/4/12

Stocks and shares ISAs have the potential to make you a lot more money than cash ISAs in the long-term. Of course, it depends what you invest in, but if you do it right and, importantly, leave your money there for years, over time you should see good returns and pay less tax.

• What is a stocks and shares ISA?
• Why is a stocks and shares ISA better then a cash ISA?
• Should I have one?
• Which is the best?
• Why we like index-tracking funds

What is a stocks and shares ISA?

Stocks and shares ISAs refer to a number of different share-based investments which can be put inside an ISA ‘wrapper’ meaning that you don’t pay tax on any gains you make.

It is important to remember that ISAs are not the investments themselves; they are just the ‘wrappers’ that protect your savings from tax. 

So putting money in a stocks and shares ISA is just the same as putting money in any stock market investment (like a fund, or shares in an individual company) but you ‘wrap’ it in a tax-saving ‘bag’ – so that when your investment grows you don’t lose any of it in tax payments.

In fact, the ISA wrapper has two advantages; it protects you from paying Capital Gains tax on profits you make from share price increases, and enables all the tax you would pay on bonds to be reclaimed.

Why is a stocks and shares ISA better then a cash ISA?

There are two reasons why a stocks and shares ISA beats cash:

1. You can save more money each tax year

You can now put up to £11,280 each tax year into an ISA – of this a maximum of £5,640 can be saved in a cash ISA, but you can save the whole lot in a stocks and shares ISA.

2. Equities (shares) outperform cash deposits over the long term

In the 2010/2011 tax year, 12 million cash ISAs were opened, compared to 3.4 million shares ISAs. Despite this, recent figures from Virgin Money show that if you had put £5,100 into a cash ISA you would have seen returns of £145 (based on a rate of 2.85%).

In contrast, the same amount invested in a stocks and shares ISA would have reaped a return of £593 (based on the 11.62% annual return of the Virgin Index Tracking Trust Isa, which tracks the FTSE All Share) before charges – a massive £448 more!

However, getting the most out of the stock market is about being in it for the long haul 

The same Virgin figures show that if you had invested in the Virgin Index Trust in the four years to January 2011 you would have suffered a loss of 3.91%.

BUT, if you invested in that trust in January 2003, you would have seen an impressive return of 63.43%.

Should I have one?

As you need to tie your money up long-term to get the best from a stocks and shares ISA, you need to make sure that you already have a nice chunk of cash savings before you consider investing.

How much depends on your personal situation, but you really need the equivalent of three months salary (though ideally six months, plus a bit extra as a buffer) at the very least.

In stock market terms, long-term means 10 years or more – making these the kinds of investments you want to cash in much further down the line (perhaps for your retirement fund).

ISAs were brought in originally to boost our savings for our old age – and that’s why we are allowed to put our full tax-free savings allowance into stocks and shares ISAs, as opposed to cash ISAs where you are limited to half the allowance. It’s an incentive to invest in equities which, longer term, offer a better return.

Which are the best?

Good question! All you have to go on with these types of investments is past performance (and perhaps your knowledge of  funds or companies you might want to invest in).

Also the type of investment you choose will depend upon your personal circumstances: your cash savings, your age, your career and your family situation to name a few.

Need a helping hand?

There are two ISA guides we recommend.

1) Take a look this Investor’s guide to ISA’s from investment experts Hargreaves Lansdown.

It’s a really useful booklet and best of all it’s completely FREE.  Click here to get your copy!

 

 2) The first guide will help you reduce your tax bill and get the most out of your ISA. This second guide from the experts at Best Invest (who were voted self-select ISA provider of the year by the Financial Times) will give you advice on how to choose ISA funds, how to invest, and show you some of the top ISA picks.

Again it’s completely free – click here to get your copy.

What else should I bear in mind?

With equities all you have to go on is how well the product has done in the past few years, how well the company has done generally and what the annual charges are (generally the lower the charges, the better the investment does long term). But none of those elements can tell you definitely which will perform the best this year, next year and in following years.

However, there are some types of equities investments that generally do well and are easy to invest in. Here is a run-down of the investments we think you should consider including:

• Index-tracking funds
• Exchange-traded funds
• Managed funds
• Individual shares

Index-tracking funds

Index-tracking (tracker) funds are simple, cheap, easy to understand – and they work. You can find out a lot more about them in our article here, but basically they work by putting a small amount of your money into every single company in the index you are tracking.

So, for example, they might use the FTSE 100, the FTSE All Share index, or even one of the foreign stock indices like the DAX in Germany or the Dow Jones in America, and they will divide your money between every company in that index.

They work by computer, and because computers don’t need payment these funds are cheap. In fact it’s rare to find a tracker fund that charges more than 1% a year to manage your money, which is a good rate. Remember the lower the charges, generally, the more money you make because less is being taken out of your fund each year.

Tracker funds are also easy to invest in and often come ‘pre-wrapped’ in an ISA which makes them even easier to buy.

Quite a few companies produce them but the one we like best – and Jasmine has invested in it a few times – is the Legal & General ISA. They are one of the biggest providers of index-tracking investments in the UK, managing £202 billion as at 30 June 2010.

It’s easy to apply. Click here and you will see a list of their trackers. You can find out more about each and pick the one you like, then start the application process. You will need your National Insurance number and your bank details but otherwise it’s pretty straightforward.

Exchange-traded funds (ETFs)

These are also quite cheap and effective. In fact, they work a bit like trackers and their charges are very low, usually less than 0.5%. Also, you don’t have to pay stamp duty on them. See our article about ETFs here for more information.

ETFs also come pre-wrapped in an ISA which makes it easier to buy them. To get an ETF, though, you need to go through a broker. We suggest TD Direct Investing as a cheap, online broker which is easy to join and use.

Managed funds

Some managed funds (that is funds that are actually ‘managed’ by real people rather than a computer) do well – sometimes very well. But the majority of them don’t. In fact about 85% of funds that are managed by the guys in the city under perform compared to the stock market. Not only that, but you are often charged a lot for the privilege of losing your money!

However, if you find a fund that has been well run by a really good fund manager, you can make great profits.  You can see how various funds have performed on the independent website Moneyspider which tracks them. Remember that even if a fund has performed well in the past, that doesn’t guarantee that it will continue to do so in the future. You will need to monitor it once a year or so to make sure that it is still worth investing in.

When you are choosing a managed fund remember that the annual fees are very important. Try to avoid ones with higher fees unless they have an exceptional track record. Also, there are some ‘star’ fund managers whose funds have consistently outperformed the stock market, and their funds are generally worth considering.

Individual shares

Entire libraries are filled with books about how to invest in shares. There are several different theories about how best to make money through shares, and some people spend a lifetime trying. Others, like multi-billionaire Warren Buffett, spend a lifetime amassing a fortune through shares.

Essentially, if you would like to invest in individual companies rather than just funds, you will need to spend some time studying the market, studying books on investment and keeping an eye on the companies you put money into. In other words, it’s not an easy ride.

If you just buy shares in a company because your friend says it’s good or a bloke down the pub gave you a tip off you are likely to lose your money. People who consistently make money by investing in individual companies are those who work at it and follow investing rules rather than their own whims.

So if you want to look into this, get reading and studying. We like the book The Naked Trader by successful investor Robbie Burns. He also recommends other works on investing in the book. Also check out investment websites such as the The Motley Fool and Interactive Investor.

If you do the work and decide on a company you want to buy into, you will need to make the transaction through a stockbroker. Happily, that doesn’t have to cost you much now that there are online stockbrokers that anyone can use. Just sign up to one, like TD Direct Investing, and you can pay as little as £8.95 per trade.

Getting started

These companies offer ISA-wrapped index-tracking funds:

• Legal and General Index Tracking ISA
• National Friendly
• M & G
• Scottish Widows
• Virgin
• Gartmore
• TD Direct Investing