It’s fair to say that Cash ISAs aren’t very exciting, even for a financial geek like me. Stocks & Shares ISAs are where it starts to get livelier. Here you can enjoy a tax-free investment portfolio, and the possibilities are limitless. As is often the case, this flexibility means that a Stocks & Shares ISA can be complicated to understand. Many of my clients opt for a Cash ISA, purely because it’s simpler. In this post, I’ll explain how a Stocks & Shares ISA works, what you can put in it, and when this might be a suitable investment.
An ISA is a tax-free wrapper, so you can ‘wrap’ your investments and protect them from tax. You’re allowed to invest up to £20,000 each year, making it possible to build a sizeable fund over time. Indeed, there are now some ISA millionaires. The main difference from a Cash ISA is that a Stocks & Shares ISA allows you to buy assets.
Whereas cash grows by only the specified interest rate (and its purchasing power might shrink due to inflation), certain types of asset give you income and the value of the asset itself could increase. For example, if you buy a share, you might receive a dividend and see the value of the share increase, meaning you could sell it at a profit. When you buy and sell shares outside of an ISA, you’re liable for tax on interest and dividends above a certain amount.
The major risk compared with cash, though, is that the value of your investments could go down. They’re subject to the whims of the stock market. For this reason, Stocks & Shares ISAs are often viewed as medium or long-term investments, as this provides the opportunity to ride out any volatility. Generally speaking, stocks and shares outperform cash over periods of 5+ years. But there are no guarantees – you won’t always receive dividends, and your ISA value could dip just went you want to use the proceeds.
You can put all sorts of assets in an ISA. I’m going to keep this simple and just focus on four main assets.
When you buy a share in a company, you own a tiny slice of it. If that company performs well, they might pay you a dividend and you could also see the value of your shares increase. The trouble with investing in individual companies is that you’re vulnerable to their fluctuating fortunes. If the CEO does something foolish, you could see your ISA value plummet. Hopefully, it would bounce back again, but that’s not helpful if you need your money immediately. This is why it’s important to hold diverse investments.
If you want to spread the risk across different companies and sectors, funds are the answer. Some funds track specific indices, such as the FTSE 100, while others are built on a sector, e.g. biotech. A fund that tracks an index tends to be cheaper, as all the buying and selling is automated. This is known as a passive fund. Funds that involve human intervention to make decisions are active funds. These are more expensive, as you’re paying the salaries of those people. There’s a lot of argument about whether active or passive is best, but passive is almost always cheaper.
One disadvantage of funds is that you can’t buy or sell them immediately – the transaction is usually completed the following day. This means it’s difficult to respond to changes in the market. So, if the FTSE 100 suddenly dipped, you couldn’t take advantage of the low prices until the next day, when the value might have partially recovered. This barrier to spontaneity can be helpful, too. As there’s usually a charge for buying and selling funds, you want to keep transactions to a minimum.
ETFs – If you do want the ability to respond to market events, you could consider Exchange Traded Funds (ETFs). These are similar to index funds, but they’re traded on the Stock Exchange like shares. Again, you’ll usually pay a fee for buying and selling them.
Bonds – A bond is a debt owed by a company or a government. In return for lending them money, they pay you interest (known as the coupon) and then settle the full amount on a specified date. If you bought a 5-year bond for £500 at 5%, you’d earn £25 per year, then receive your £500 back after 5 years. Bonds tend to be safer and less volatile than shares. Cautious investors often plump for a high bond to shares ratio. At the moment, though, it’s difficult to find inflation-beating bonds, so they don’t always offer the growth that many investors require.
A big factor in choosing a Stocks & Shares ISA is the charges. Most providers levy:
Charges can appear insignificant, but they build up over time. For instance, if you accumulated £100,000 in your ISA and paid a 2% charge, you’d be sacrificing £2,000 each year. This could wipe out any profits during a slow period. Another major factor is your attitude to risk. Some funds dangle the prospect of double-digit gains, but they’re also susceptible to double-digit losses.
There are three main routes to creating a Stocks & Shares ISA:
If you’re a nervous beginner, there are providers who will assess your attitude to risk and put together a suitable portfolio comprising funds and bonds across a range of sectors and regions. You just need to decide how much to invest each month. These companies are often referred to as Roboadvisers. The management fees tend to be quite high, but you avoid transactions costs and all the hassle of managing your own investments. To learn more about what’s available, visit the Boring Money guide to Roboadvisers.
Some providers offer funds (baskets of shares and bonds) for specific purposes, for example, retirement in 10, 20, 30, or 40 years’ time. Others give you easy access to specific markets, such as emerging economies. You just buy a chunk of that fund each month and they do the rest. Unlike a Roboadviser ISA, you could decide to switch those funds at any time, or mix and match a few of them. Take a look at MoneySavingExpert for recommendations and more information.
Anyone who’s feeling more intrepid can choose their own funds, shares, ETFs, and bonds. This gives you maximum control, but also maximum responsibility. If you’re new this area, experiment with small amounts first. And don’t forget about the transactions charges. For an excellent beginner’s guide to investing, hop over to Pete Matthew’s Learn How to Invest course. It’ll cost you £175, but this is top quality material and it could help you avoid some costly mistakes.
As you’ve probably gathered, the behaviour of a Stocks & Shares ISA is more unpredictable than its cash equivalent. The upside, though, is that it might perform better in the long term. If you’re looking for growth, you’re more likely to achieve it with investments, especially when interest rates on cash ISAs are low. Generally, a Stocks & Shares ISA is suitable if you don’t need to access your money for at least five years and you’re prepared to tolerate the value fluctuating in the meantime. Some people use a Stocks & Shares ISA to fund retirement, which I covered in an earlier post.
When considering a Stocks & Shares ISA, look at the following factors:
If a Stocks & Shares ISA seems too daunting at the moment, fear not. Next time we’ll look at how you can get a guaranteed 25% return on a cash ISA, provided you’re under 40.
Please note: This does not constitute investment advice. The value of stocks and shares can go down as well as up. As a financial coach, I never recommend a specific product or course of action. If you’re making a significant investment decision, you should consider speaking to an Independent Financial Advisor.