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. 

Why invest?

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).

Portfolio builder

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."

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