Grow your nest egg with a stocks and shares ISA
If you'd like to invest in the stockmarket, then it's worth looking at a stocks and shares ISA. These offer a number of tax breaks and, providing you're prepared to take a little more risk with your money, will potentially deliver better performance than sticking with cash.
You can invest up to £10,200 in a stocks and shares ISA in 2010/11, with this figure rising to £10,680 in 2011/12. However, this maximum is reduced by anything you put into your cash ISA (up to £5,100 in 2010/11 and £5,340 in 2011/12).
In terms of the tax breaks, all stocks and shares ISAs are free of capital gains tax, so no matter how much money you make, you won't need to share your good fortune with the taxman when you cash in your ISA.
On the income tax side, the position varies. The income from interest-bearing assets such as gilts and corporate bonds are tax free, but if you invest in equities that pay dividends the situation is slightly different. A tax credit of 10% is deducted at source from dividends, and this cannot be reclaimed.
If you're a basic-rate or non-taxpayer, this means you won't see a difference in the level of income you receive either inside or outside the ISA wrapper. But there's an advantage for higher-rate taxpayers, who would otherwise be walloped for a further 22.5% tax on any dividends received outside the ISA wrapper.
There's one key reason why you shouldn't overlook your stocks and shares ISA - performance.
"It's not guaranteed, but over time you should see better returns from stocks and shares than from cash," explains Tim Cockerill, head of research at Ashcourt Rowan.
"It won't be a nice smooth path because investment returns can be volatile, but as long as you're patient you should be rewarded."
As well as tapping into the potential for higher returns over the long term, if you ignore stocks and shares ISAs, you're forfeiting at least £5,100 of your annual ISA allowance each year (£5,340 in the 2011/12 tax year).
Also, although the income tax position means basic-rate and non-taxpayers are no better off investing inside an ISA, Cockerill says there are still significant tax breaks.
"There are still capital gains tax advantages, plus you never know whether you'll be a higher-rate taxpayer in the future," he says. "It won't cost you any more than investing outside of an ISA wrapper and it's always worth taking advantage of a tax shelter, even if you don't seem to be benefiting that much now."
Who should invest?
Stocks and shares ISAs don't suit everyone, however. Although there are different levels of risk, whatever you decide to invest in could fall in value as well as rise. If you feel uncomfortable about this, a stocks and shares ISA is probably not worth considering.
You also need to be prepared to leave your money invested for the long term. "You need to be able to leave your money for at least five years, ideally longer," says Ben Yearsley, investment manager at Hargreaves Lansdown.
"Its value will fluctuate over time, so you also need to feel comfortable that you are able to leave it to recover."
The power of the collective
If you're happy with the way a stocks and shares ISA works, one of the best ways to invest is through a collective investment or fund. You can choose from a number of options, such as a unit trust, open-ended investment company (OEIC), or an investment trust.
There are thousands to pick from, investing in everything from UK blue-chip companies to smaller companies in the emerging markets. You do have to pay to invest - initial charges are around 5% and annual ones around 1.5%.
However, if you buy through a fund supermarket or a discount broker, you'll usually be able to secure a hefty discount on the initial charge, often wiping it out completely.
Investing in a fund brings a number of advantages, with diversification at the top of the list. Diversification is important when investing because if you spread your money across a range of different stocks and shares, if one of them performs badly, it won't have too devastating an effect on your overall portfolio.
And, chances are, one or more of the other stocks and shares you're holding will perform better than expected, so you won't even notice the poor performer.
"If you buy stocks and shares directly, the costs and the work involved researching which ones to buy will mean you're fairly limited as to how many you can buy. But by buying a collective investment, you'll instantly have exposure to 40, 50, 100 or more stocks and shares. This will give you great diversification," says Yearsley.
For example, take £10 as your dealing charge. If you invested your full ISA allowance of £10,200 across 50 different shares this would cost you £500 plus 0.5% stamp duty, equivalent to a further £51. This would wipe a whacking £551, or 5.4%, off the value of your investment.
By comparison, if you invested through a fund supermarket, you might be able to sidestep the initial dealing charge altogether because of the bulk-buying deals that are in place.
As well as doing away with the costs and the work involved with managing your investment yourself, if you invest through a fund, or funds, you'll also benefit from the skills and experience of a professional fund manager. They will have access to all the research necessary to pick those stocks and shares with the best potential to deliver performance.
Open or closed?
Although there are a variety of collective investments, you should consider the different structures when deciding which to invest in. Unit trusts and OEICs are open ended, meaning they will keep issuing units to meet demand, while investment trusts are closed ended, consisting of a finite number of shares.
When an investment trust is in demand, it can trade at a premium, which means people are prepared to pay extra for it. However, when it falls out of favour, this can slip to a discount, shrinking the value of your investment.
Another key difference is an investment trust can borrow money to invest (gear) and, hopefully, boost performance.
These differences can affect the return you receive. Cockerill explains: "Investment trusts do tend to deliver better performance in a rising market as they can borrow money and any discount narrows, but they can also catch you out by dropping faster when markets are falling."
Assess your assets
As well as deciding which type of collective fund to invest in, you also need to determine where you'd like to invest.
There are three main asset classes - fixed interest, which includes corporate bonds and gilts; property, which is usually commercial rather than residential; and equities, which are commonly known as shares. Each has different characteristics and risk profiles.
Fixed interest is the lowest risk. This can be useful for generating an income, although there's still a danger of default and the value of your investment falling. It does have an advantage over the other asset classes in that it produces interest rather than dividends, so it's completely tax free.
Next on the risk scale is property. Investing in bricks and mortar should deliver a steady, rising income stream, with the prospect of capital growth. However, in crunch times, you can experience issues with liquidity, as the assets can be notoriously difficult to shift if people are exiting a property fund.
Shares are usually the riskiest asset class, as your return depends entirely on the fortunes of the company. Many pay dividends, which can produce a good income stream, and most aim for good capital appreciation over time.
But Cockerill warns against taking too simplistic a view on risk. "Under present market conditions, I'd say property was lower risk than fixed interest. With yields compressed, it's hard to see any upside, and when interest rates start rising there could be a sharp correction in the bond market. The order isn't really fixed, but over the long term you can expect them to be ranked in this order."
Other factors influencing risk include the size of the company you're investing in (with larger companies seen as less risky than small ones) and the area of the world you've picked (with well-developed markets less volatile than emerging economies).
Whether you decide to invest in one, two or three of the asset classes, you should also think about how you'll construct your investment portfolio. Although a fund will give you plenty of diversification, having a number of funds in your portfolio will give you a broad spread of investments and a variety of different management styles.
How much money you have to invest will dictate how many funds you buy. For instance, if you only have a small amount to invest - say £1,000 - you can invest in one or two funds.
If you have more to invest, you can add more funds to your portfolio, but Yearsley recommends a maximum of 25: "You don't get any bang for your buck with an extra fund. Any upside is too small to make a real difference to the overall performance.".
Whatever you decide to invest in, it's prudent to review your portfolio every six months to make sure everything's in order. "People get fixated about checking performance on a much more frequent basis, but this is pretty pointless," says Yearsley.
"You should look at your funds when you get your ISA statement and rebalance your portfolio as required."
Open-ended investment companies are hybrid investment funds that have some of the features of an investment trust and some of a unit trust. Like an investment trust, an Oeic issues shares but, unlike an investment trust which has a fixed number of shares in issue, like a unit trust, the fund manager of an Oeic can create and redeem (buy back and cancel) shares subject to demand, so new shares are created for investors who want to buy and the Oeic buys back shares from investors who want to sell. Also, Oeic pricing is easier to understand than unit trusts as Oeics only have one price to buy or sell (unit trusts have one price to buy the unit and another lower price when selling it back to the fund).
Investment trusts are companies that invest money in other companies and whose shares are listed on the London Stock Exchange. As with unit trusts, private investors buying shares in an investment trust are buying into a diversified portfolio of assets (to reduce risk), which is managed by a professional fund manager. Investment trusts differ from unit trusts in two important ways: they are listed on the stockmarket and so are owned by their shareholders and are closed-ended funds with a finite number of shares in issue. This means the share price of investment trusts might not reflect the true value of the assets in the company (known as the net asset value, or NAV) and if the NAV value of a share is £1 and the share price in the market is 90p, the trust is said to be running a discount of 10% to NAV. But this means the investor is paying 90p to gain exposure to £1 of assets. Investment trusts can also borrow money and use this money to buy investments. This is known as gearing and a geared trust is thought to be more of an investment risk than an ungeared one.
A hugely unpopular tax paid on property and share purchases. Stamp duty on property is levied at 1% for purchases over £125,000 (£250,000 for first-time buyers) which then moves up at a tiered rate. For property between £125k and £250k you pay 1%, then 3% from £250k up to £500k and then 4% from £500k to £1m and then 5% for properties over £1m. But unlike income tax, which is “tiered” and different rates kick in at different levels, stamp duty is a “slab” tax where you pay the rate on the whole purchase price of the property. On shares, stamp duty is charged at a flat rate of 0.5% on all share purchases. Figures correct as of May 2011.
A collective investment vehicle (known in the US as a “mutual” or “pooled” fund) and similar to an Oeic and investment trust in that it manages financial securities on behalf of small investors who, by investing, pool their resources giving combined benefits of diversification and economies of scale. Investors buy “units” in the fund that have a proportional exposure to all the assets in the fund, and are bought and sold from the fund manager. The price of units is determined by the value of the assets in the fund and will rise or fall in line with the value of those assets. Like Oeics (but unlike investment trusts) unit trusts and are “open ended” funds, meaning that the size of each fund can vary according to supply and demand of the units form investors. Unit trusts have two prices; the higher “offer” price you pay to invest and the “bid” price, which is the lower price you receive when you sell. The difference between the two prices is commonly known as the bid/offer spread.
There are limits to how much you can invest in any tax year. For 2011/12, the limit is £10,680. Of that, the maximum you can invest in cash is £5,340 and the balance of £5,340 can be invested in shares (individual company shares or investment funds). If you don’t take the cash ISA allowance, you can invest up to £10,680 into a stocks and shares ISA.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
An individual employed by an institution to manage an investment fund (unit trust, investment trust, pension fund or hedge fund) to meet pre-determined objectives (usually to generate capital growth or maximise income) in prescribed geographic areas or investment sectors (such as UK smaller companies, technology or commodities). The manager also carries the responsibility for general fund supervision, as well as monitoring the daily trading activity and also developing investment strategies to manage the risk profile of the fund.
The familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.
Capital gains tax
If you buy an asset – shares, a second home, arts and antiques – and then sell it at a later date and make a profit, that profit could be subject to CGT. You don’t pay CGT on selling your main home (which is why MPs “flipped” theirs so regularly) or any securities sheltered in an ISA. Individuals get an annual CGT allowance (£10,600 in 2010/2011) but if you have substantial assets it’s worth paying an accountant to sort it for you.