As we always say, don’t be scared of stocks and shares ISAs! With a little knowledge and a willingness to take (even small) risks, an equities ISA can easily out-perform your cash ISA over the long-term.
We’ve banged on about this in detail in this article – but the short version of it is this: cash ISAs have low interest rates that don’t keep up with inflation. That means you’re effectively losing money if you leave it in a cash ISA long-term.
If you’ve got money that’s just sitting in a savings account (we’re not talking about your emergency or rainy day fund – we mean the spare savings after that essential buffer), open an equities ISA.
But there are so many types to choose from! For an investing novice, it’s overwhelming. Use this guide to figure out which stocks and shares ISA type appeals to you.
- What is a stocks and shares ISA?
- Why is a stocks and shares ISA better than a cash ISA?
- Should I have one?
- Which is the best?
- Why we like index-tracking funds
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.
You can hold a cash ISA and an equities (stocks and shares) ISA. Your total ISA allowance each year is currently £20,000. You can choose to put the full allowance into one ISA, or split it between the two types.
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 stocks and shares investments (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.
You don’t pay tax on the first £2,000 income generated from dividends each year, either. A dividend is what companies pay out to people who own their shares when the company has performed really well. Check out our article on high yield dividends for more information.
Equities (shares) outperform cash deposits over the long term
What does this mean for your money?
Let’s say that back in 2018 you saved the full £20,000 on a one-year fixed-term rate of 2%. Interest at the end of the first year is £400, so your total amount is £20,400.
The inflation rate in 2018 was 2.48%. Your ISA still paid only 2% in interest.
In real terms, you’ll actually have LOST money, despite earning the £400 interest. That’s because your interest rate did not keep up with inflation.
If, however, you’d invested your full allowance into a stocks and shares ISA with a modest return of 5%, you’ll have beaten inflation and grown your wealth by £1000 instead of the £400 if you left the same money in a cash ISA. Even taking into account the account management fees of an equities ISA, you’re still richer than if you’d left the money in a cash ISA.
Now, this is the bit where we say the important thing: stocks can go down as well as up. It may look like you’ve lost money if you’re only looking at the annual performance in one year.
This is the biggest difference between cash and equities ISAs: a stocks and shares ISA performs MUCH better if you play the long game. It helps you ride out blips in the market to benefit overall gains through a longer period. We say that for stocks and shares investments you need to keep your money there for at least five years (ideally ten) in order to allow the ups and downs of the market to smooth out.
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 to fall back on before you consider investing.
How much cash you hold 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, to be an addition to our pension, and that’s why for a long time we were only allowed to put our full tax-free savings allowance into stocks and shares ISAs, as opposed to cash ISAs where you were limited to half the allowance (this is no longer the case). It was an incentive to invest in equities which, longer term, offer a better return.
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.
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 (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.
Which ISA provider should I try? At time of publication, Vanguard topped every recent poll for ‘best index tracking fund ISA’, as well as having low charges and fees. You could also give Hargreaves Lansdown or Legal & General as alternatives with good reputations, too.
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.
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 75% of funds that are managed by the guys in the City under-perform compared to the general performance of 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.
…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.
A newish trend, robo-advisors use the concept of a managed fund…but with robots. OK, OK, with computer algorithms.
These platforms allow you to choose your level of risk and your preferred fund type(s), then set to work doing the investing for you. You get the benefit of fancy computer intelligence and a hands-off investment approach, but without the hefty cost of managed funds.
You can add your money as you like in lump sums or with a regular deposit. If you want to up your risk/reward level, that’s easy to do within the platform. Perhaps the best bit is that you can practice using virtual portfolios before you spend any money!
Robo-investment platforms are also a great way to get started with a small pot of money – you can open an account with as little as £1 for some platforms. Try reputable robo-advisors like Nutmeg if this sounds like the option that’d suit you.
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 quite some time and effort studying the market, reading 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. Start with my book ‘Beat the Banks‘. The number one tome for anyone wanting to be a serious investor like Warren Buffett is ”The Intelligent investor‘ by Benjamin Graham. Also check out investment websites such as The Motley Fool and Interactive Investor.
*This is not financial or investment advice. Remember to do your own research and speak to a professional advisor before parting with any money.