Boost your ISA with stocks and shares

If you're looking to invest for the long term and you're comfortable taking some risk with your money, a stocks and shares ISA is worth considering.

As well as allowing you to invest in a variety of different assets - such as shares, bonds and property - these also let you take advantage of your full ISA allowance each year.

It could also make you richer. "It's not guaranteed but, in exchange for taking additional risk with your money, you should receive a higher return," explains Patrick Connolly, certified financial planner at AWD Chase de Vere. "It'll be a bumpy ride but if you can leave your money invested, it should perform better than a cash ISA."

This is supported by research conducted by Barclays Capital. In its Equity Gilt study, Barclays found that over each decade since 1900, apart from 2000 to 2010, stocks and shares outperformed cash.

But to stand a chance of generating these higher returns, you do need to invest for the long term. "You need to be prepared to invest for at least five years, ideally 10 years plus," says Patrick Murphy, chartered financial planner with Zen Wealth.

"You could get a great return if you invest for a year, but it is best to take a long-term view when investing in stocks and shares. Stockmarkets can be volatile so if you do lose some money, there is time for its value to recover."

Find the best Cash ISA or savings account for you

The mechanics

Stocks and shares ISAs offer a number of tax breaks. Any profits you make from your investments are free of capital gains tax, and many investors will also benefit from the tax treatment of the income they receive.

The capital gains tax exemption can be a significant advantage, especially once you've built up a chunky portfolio. Outside an ISA, any profits you make in excess of the annual allowance would be subject to capital gains tax at 18% for basic-rate taxpayers and 28% for higher-rate and additional-rate taxpayers.

On the income side, a 10% tax credit will be deducted from any dividends paid to you, but there is no further income tax to pay.

Although this means basic-rate taxpayers are no better off from an income tax perspective, higher-rate and additional-rate taxpayers save 22.5% and 32.5% respectively in income tax on dividends.

All taxpayers stand to gain if they use their ISA to invest in fixed-interest investments such as gilts and corporate bonds. As income paid on these investments is classed as interest, it is paid tax-free in exactly the same way as interest paid on a cash ISA.

Given the tax breaks that stocks and shares ISAs offer, the Treasury sets an annual limit on the amount of money you can invest in them.

In the 2013/14 tax year the maximum you can invest is £11,520 (£11,280 in 2012/13), although this will be reduced by anything you put in your cash ISA, up to the maximum limit of £5,760.

Although the prospect of using the full allowance may be tempting, Connolly recommends you make some solid financial foundations first.

"Make sure you have some cash savings in place before you start investing in a stocks and shares ISA. This will ensure that you're sorted if you do need some money in an emergency, as you can't guarantee it will be the right time to tap into your investments," he says.

Investment options

As well as working out how much to invest, you'll also need to decide where to invest your money.

Through a stocks and shares ISA you have access to a wide range of investments, including UK and international shares, gilts and corporate bonds, exchange traded funds and investment trusts and funds. You can even hold your money in cash within a stocks and shares ISA temporarily, providing you intend to invest it at some point.

These investments do tend to have different risk profiles and characteristics. This means that certain investments may be more suitable if you're looking to achieve a particular objective or you want to take a particular level of risk.

At the lower end of the risk spectrum are fixed-interest investments such as corporate bonds and gilts. These are loans to companies and governments, so the return you receive is made up of the interest they pay plus the repayment of the loan.

Connolly adds: "Fixed-interest investments can suit all investors, especially those looking for income. There is some risk of default, but this will vary according to the organisation taking the loan. It's also worth bearing in mind that the more risk you're prepared to take, the higher the level of interest you could potentially receive."

A government is fairly likely to repay its debt so government bonds, which are also known as gilts, are usually the safest fixed-interest investment.

Next on the risk spectrum are investment-grade bonds, which are loans made to blue-chip companies. After these come high-yield or junk bonds, which are issued by smaller companies and those where the risk of default is higher.

Commercial property is another asset class worth considering in your portfolio. This can be accessed through funds either in the form of bricks and mortar or property company shares.

Returns are generated through rental income as well as capital appreciation. While there is always demand for commercial property, there are risks, as were experienced with the property crash in 2008. This means property is widely seen as more risky an investment than fixed interest.

Next on the risk spectrum are shares. These generate a return for investors through growth in the value of the company but also through the distribution of its profits in the form of dividends.

Just like fixed interest, shares can range from very low risk to off-the-scale levels of risk.

Connolly explains: "A large, secure company will be relatively low risk but a small one operating in a specialist market, such as technology or pharmaceuticals, will be much more risky. It's important to pick the level of risk that suits you."

Collective investments

While you can hold individual shares or bonds in a stocks and shares ISA, most investors prefer to use collective investments, such as unit trusts and investment trusts, to form the basis of their portfolio.

These funds hold anything from around 20 different shares, commercial property or fixed-interest holdings to 200 or more, selecting them according to set investment objectives. For example, a UK Equity Income fund will invest in the shares of UK companies that set out to pay dividends, while a Sterling High Yield fund will invest in fixed-interest investments that pay high levels of income.

Investing in funds offers a number of advantages, as Murphy explains: "A fund can be an instant portfolio, giving an investor access to a well-diversified range of investments. This reduces the risk of losing all your money if one holding fails. It can also be cheaper than investing directly. While it can cost around £12 when you buy or sell a share, you can buy funds for a fraction of a percentage."

While it is possible to buy funds for your ISA directly from a fund management company, the best way to buy them is through a fund platform, supermarket or discount broker. These offer cost savings.

For example, on Hargreaves Lansdown's Vantage ISA platform, discounts of up to 5.5% are available on many of the initial charges and there is no annual management charge on more than 2,400 funds. Meanwhile, Interactive Investor offers a rebate of 100% of income and commission on funds.

Buying through one of these routes offers administrative benefits. As well as being able to see all your ISA investments in one place, you can spread your investments across different fund managers rather than having to stick to one company, switching them whenever you fancy.

Additionally, many platforms come with a range of tools and information to help you achieve your investment strategy. These can include portfolio analysis tools, so you can see exactly where you're investing, and analyst tips to help you pick the top performers.

Building your portfolio

With more than 3,000 funds to choose from, deciding where to start your stocks and shares ISA can be tricky. Murphy recommends starting with a very general fund. "Look for a well-managed fund that gives a broad spread of shares and fixed interest across a wide geographical area," he says. "This will give you an instant portfolio which you can build on and personalise as your ISA grows."

As an example, if you want to invest to generate an income, you could add equity income or fixed interest funds, selecting funds in line with your appetite for risk. Similarly, if you are investing for your retirement in 20 years' time and you're happy to take a risk, you could choose funds investing in some of the more volatile sectors that deliver potentially higher returns - technology, for instance.

Information on funds - including their risk profile and past performance - can be found on many of the platforms to help your make your selections. Alternatively, you can consult an independent financial adviser who will help you structure your portfolio, although they will expect to be paid for this service.

As well as spreading your portfolio across a number of funds, another strategy worth considering when you're building up your stocks and shares ISA is to invest on a regular basis. By drip-feeding money into your ISA every month you can take advantage of pound cost averaging, whereby you're able to buy more units when prices have fallen.

For example, say you were to invest £100 a month. In the first month the price of a unit is £1, so you're able to buy 100 units. The following month units fall in price to 95p, so you buy 105 units. This approach would give you a total of 205 units rather than the 200 you would have bought if you had invested the full £200 at the outset.

However you decide to build your stocks and shares ISA, it's also important to review your portfolio regularly. Connolly recommends checking everything is in order every six months or so. "Look at the performance of your funds and compare it to other similar funds to see whether they're up to scratch," he explains. "Funds won't always increase in value, but make sure the performance is at least in line with the market."