Is it time to ditch your cash ISA?
These can invest in a wide range of assets, from low-risk government bonds through to riskier smaller companies and emerging markets.
Although investing in the stockmarket means the value of your investment could fall as well as rise, there are a number of reasons why you might want to consider investing in a stocks and shares ISA.
For a start, you might have spent the last 11 years (ISAs were introduced in 1999) focusing solely on building up your cash ISAs.
If you had taken advantage of the full allowance each year (£34,200 or £35,700 if you're 50-plus), this could now be worth £36,016, according to Moneyfacts.
However, it also means that you missed out on £43,200 of your ISA allowance, or £44,700 if you're over 50, by not using your stocks and shares allowance.
And you're not only throwing away this allowance – by only putting your money in cash you might be exposing yourself to more risk than you imagine. Over the long term, inflation can erode the value of your savings.
For example, if inflation is 3%, over 10 years the buying power of £10,000 would reduce to £7,441 in real terms.
The only way to counter this is to look for accounts that pay more than the rate of inflation as, even if you receive interest at 2% on your savings, if inflation is 3% you'll still see the buying power of your £10,000 reduce, falling to £9,070 over 10 years.
Additionally, by holding both cash and stocks and shares you create a much more diversified portfolio. This improves your chances of achieving exposure to whichever asset is performing strongly.
As well as considering your overall saving and investment strategy, there are also some rules about investing in the stockmarket that might help you decide whether it's right for you.
First, it's essential that you have time on your side. The value of stocks and shares do rise and fall so you need to be able to give them time to recover if necessary.
Because of this, experts recommend you only consider stocks and shares ISAs if you have an investment horizon of at least five years, and longer for riskier assets such as emerging markets.
Likewise, if you're investing in the stockmarket, it needs to be money you won't need in an emergency. Having to withdraw your money to pay for an unexpected garage bill or for property repairs could mean you'll be forced to take a hit on your investment.
While time can help to ensure the value of your investment gets a chance to recover, investing in stocks and shares can be very bumpy, with the value of your investment falling as well as rising.
As this is very different to the gentle rise in value of your money in a cash ISA, you have to be sure you feel comfortable with it. If the thought of losing money makes it hard to sleep at night, don't do it.
According to the Investment Management Association, just shy of £100 billion has been invested into unit trust and OEIC ISAs since they were introduced in 1999.
Investing in a collective investment fund also delivers a number of advantages. Holding anything from 20 to 1,500 different investments in their portfolios, they are an ideal way to get diversification.
This is important from a risk-management perspective because if you hold a spread of investments you'll be less affected if one of them fails than if you only have investments in two or three companies.
Additionally, depending on the type of fund you choose, you'll benefit from the experience and expertise of a professional manager or management team.
Although it's no guarantee they'll beat the market, fund managers have experience in managing investments that should help deliver performance. They also have access to research that can help them determine whether an investment opportunity is worth taking.
Many meet with the management teams behind the companies they invest in, giving them the sort of insight a private investor can rarely obtain.
It can also be cost-effective to invest in funds. If you set out to achieve the same spread of investments it would cost a small fortune in dealing charges, potentially more than your actual investment if you were replicating a very diverse portfolio.
Other annual charges come into play too, such as the trustee fees, so it's worth checking out total expense ratio (TER) figures as these will show the true annual cost of the fund.
For investment trusts, which are bought like shares, you'll pay dealing charges and stamp duty when you buy them. There's also a spread between the bid and offer price, although this is usually very slim.
You'll also pay annual charges, expressed through the TER. These are usually lower than on unit trusts with the larger investment trusts charging as little as 0.5% a year.
If you do decide to invest your stocks and shares ISA in collective investments you'll have plenty of choice. There are around 2,000 unit trusts and OEICs, and a further 300 or so investment trusts to choose from.
While this can be bewildering, you can narrow down your choices by deciding where you want to invest.
Main asset classes
There are three main asset classes when it comes to ISA investments – fixed interest, equities and commercial property. Each has its own characteristics and risks.
Fixed interest, or bonds, is an investment in a loan. This loan could be made to a company, known as a 'corporate bond', or to a government, known as a 'gilt' when it's made to the UK government.
You'll receive a regular income from the interest on the loan until the end of the term when the loan is repaid. You also pay to hold the bond.
The price varies with market conditions – for example, if inflation rises, the level of interest could look less attractive compared with other investments, and the price of the bond will fall.
You can buy and sell on the bond market but, when the term ends, you'll receive the full value – known as the 'nominal value' – of the bond.
Although regarded as a lower-risk investment than equities, bonds themselves can run from low-risk to high-risk depending on the possibility that the company will default.
The lowest risk are government bonds, followed by investment-grade corporate bonds, which are companies with good credit ratings, and then high-yield or junk bonds, where the risk of default is high.
In terms of return, you can expect to get anything from around 2% to 15% or more a year.
Equity is another name for shares in companies. When you invest in a share you effectively own a proportion of the company and the value of this will be affected by the fortunes of the economy as well as of the company itself.
As well as achieving an increase in the value of the share over time, you may also receive a dividend from the share.
There is plenty of variety in the types of company you can invest in, affecting the risk you take on and the level of growth and dividend you can expect.
As a rule of thumb, large UK companies present the lowest level of risk, and the shares of small companies in emerging markets the highest.
Like for like, you can expect a higher level of return from shares than from bonds, but returns can fluctuate greatly.
You also need to consider whether you want to have an actively managed fund, where the investments are selected by the fund manager, or a passively managed fund, where the holdings replicate an index such as the FTSE All-Share or the FTSE 100.
Although charges are lower on passively managed funds, you forfeit the possibility of beating the index, which a fund manager should – but won't necessarily – be able to do.
Commercial property is a relatively new addition to the ISA investment arena, only coming into the frame at the end of 2005 to satisfy the British appetite for bricks and mortar.
An investment in property has the potential to deliver capital growth as property prices rise, but also income, in the form of rent from a tenant.
However, it's not without risks as investment in property can be very illiquid, making it difficult to sell especially when prices fall. This resulted in some property funds imposing restrictions on withdrawals when the market plunged into turmoil at the end of 2007.
Although you can get decent returns from property, its illiquidity means it must be regarded as a long-term investment.
Do your research
Faced with all this choice and different levels of risk, it pays to research your stocks and shares ISA selection.
Magazines such as Moneywise and our sister publication Money Observer, as well as the financial sections of the national newspapers, will give you an insight into what the experts are recommending, but be sure to bear in mind your own investment objectives and attitude to risk.
Whether you go with the experts or make your own fund choices, it's worth checking on past performance on websites such as Interactive Investor and Trustnet.
Although strong past performance is no guarantee of future returns, it can help you determine which funds are worth your investment.
Rather than looking at the headline figures, look at the performance of the fund compared with its peer group over a range of periods. This will give you an indication of whether or not it consistently performs well.
Once you've made your selection, you come to the actual buying process.
Probably the worst way to buy funds is direct from the management group as they will charge you the full initial and annual charge, even though part of these charges is designed to pay commission to an adviser helping you make a fund selection.
An IFA can help, but a discount broker or fund supermarket will be cheaper if you're prepared to buy without advice.
All investment returns are measured against a benchmark to represent “the market” and an investment that performs better than the benchmark is said to have outperformed the market. An active managed fund will seek to outperform a relevant index through superior selection of investments (unlike a tracker fund which can never outperform the market). Outperform is also an investment analyst’s recommendation, meaning that a specific share is expected to perform better than its peers in the market.
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.
Total expense ratio
Most investment funds levy an initial charge for buying the units/shares and an annual management fee but other expenses also occur in running the fund (trading fees, legal fees, auditor fees, stamp duty and other operational expenses) which are passed on to the investor and so the TER gives a more accurate measure of the total costs of investing. The TER is especially relevant for funds of funds that have several layers of charges. Unfortunately, investment fund companies are not obliged to reveal TERs and many only publish the initial charges and annual management charge (AMC).
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
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.
A financial adviser who is not tied to any financial services company (such as a bank or insurance company) and is authorised by the Financial Services Authority (FSA). They can advise on financial products to suit your circumstances. All IFAs have to give consumers the choice of paying by fees or commission and have to explain which would best suit the customer in that particular instance. Also, if commission is paid either by the client or the financial service provider recommended by the IFA, the IFA must disclose what that commission is.
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.
If you own shares in a company, you’re entitled to a slice of the profits and these are paid as dividends on top of any capital growth in the shares’ value. The amount of the dividend is down to the board of directors (who can decide not to pay a dividend and reinvest any profits in the company) and they will be paid twice yearly (announced at the AGM and six months later as an interim). Dividends are always declared as a sum of money rather than a percentage of the share’s price. Although dividends automatically receive a 10% tax credit from HM Revenue & Customs (HMRC), which takes the company having already paid corporation tax on its profits into account. Dividends are classed as income and, as such, are liable for personal taxation and so shareholders have to declare them to HMRC.
Corporate bonds are one of the main ways companies can raise money (the other is by issuing shares) by borrowing from the markets at a fixed rate of interest (the reason why they are also known as “fixed-interest securities”), which is called the “coupon”, paid twice yearly. But the nominal value of the bond – usually £100 – can fluctuate depending on the fortunes of the company and also the economy. However it will repay the original amount on maturity.
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).
A market-weighted index of the 100 biggest companies by market capitalisation listed on the London Stock Exchange. It is often referred to as “The Footsie”. The index began on 3 January 1984 with a base level of 1000; the highest value reached to date is 6950.6, on 30 December 1999. The index is “weighted” by how the movements of each of the 100 constituents affect the index, so larger companies make more of a difference to the index than smaller ones. To ensure it is a true and accurate representation of the most highly capitalised companies in the UK, just like football’s Premier League, every three months the FTSE 100 “relegates” the bottom three companies in the 100 whose market capitalisation has fallen and “promotes” to the index the three companies whose market capitalisation has grown sufficiently to warrant inclusion. Around 80% of the companies listed on the London Stock Exchange are included in the FTSE 100.
Annual management charge
If you put money in an investment or pension fund, you’ll not only pay a fee when you initially invest (see Allocation Rate) but also a fee every year based on a percentage of the money the fund manages on your behalf. Known as the AMC, the actual percentage varies according to the particular fund, but the industry average for active managed funds is 1.5%.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
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.
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.