Is it time to ditch your cash ISA?

While your cash individual savings account makes up half of your annual ISA allowance, if you want to take full advantage of the tax breaks you should consider a stocks and shares 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.

Beating inflation

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.

Further, although the recent history of the stockmarket might suggest otherwise, over time equities do tend to outperform cash.

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.

Long-term vision

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.

Using a collective investment such as a unit trust, open-ended investment company (OEIC) or an investment trust, is a popular way to use your stocks and shares ISA allowance.

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.

The charges associated with collective investments are much lower. Funds such as unit trusts and OEICs have an initial charge of up to 6%, plus an annual management charge of up to 2%.

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.

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