Whether you want a potentially higher return than you get from your cash ISA; you'd like a more tax-efficient way to invest in the stockmarket; or you'd simply like to make full use of your annual ISA allowance, a stocks and shares ISA is worth considering.
These allow you to invest in a wide variety of stockmarket-related assets, including shares, government bonds (gilts), corporate bonds, investment trusts and unit trusts - and pay less tax than if you held the same assets outside of an ISA.
Stocks and shares ISAs are exempt from capital gains tax (CGT). Outside of the ISA wrapper, you would have paid CGT on any profits in excess of the annual tax-free allowance (£10,600 in 2011/12) at 18% if you're a basic-rate taxpayer or 28% if you're a higher-rate taxpayer.
Higher-rate taxpayers additionally benefit from paying less tax on any dividend payments they receive. Outside of an ISA, they'd have to pay 32.5% tax on dividends but within an ISA wrapper they don't have to pay any tax, bar the 10% tax deducted at source. But for basic-rate taxpayers, who would only have to pay 10%, there are no further savings.
The income tax position is slightly different for fixed-interest investments such as gilts and corporate bonds. With these, because the income is classed as interest, it is treated in the same way as interest paid on a cash ISA, meaning that all taxpayers are better off investing within the wrapper.
You can invest your full ISA allowance in a stocks and shares ISA, although this will be reduced by anything you put into your cash ISA. With the cash ISA allowance of £5,340 in the 2011/12 tax year, the maximum you can invest in a stocks and shares ISA is anything from £5,340 to £10,680. From the start of 2012/13 tax year on 6 April, the allowance will increase to £11,280, of which up to £5,640 could go into a cash ISA.
CASH VERSUS STOCKS AND SHARES
While some investors save into a stocks and shares ISA to take advantage of their full ISA allowance, others do so because of the potential for higher returns. "Over the long term, the additional risk you take with stocks and shares should be rewarded with higher returns," says Jason Witcombe, director of Evolve Financial Planning. "Over most five-year periods you would be better off investing in the stockmarket than in cash." But there is a price to pay for this additional potential return.
Stocks and shares ISAs are more risky and, unlike cash, the value of your investment could fall rather than increase. There are ways to reduce the likelihood of this happening.
First, it's essential to give your money sufficient time to ride out the ups and downs of the stockmarket. As a minimum you need to be able to leave your money for at least five years, ideally longer.
Additionally, as stockmarkets can behave unexpectedly, it's important that you're not relying on the money. For instance, if your stocks and shares ISA is worth £5,000 and you know you need it to pay off a car loan in a year's time, it may be sensible to move it to less risky assets or move it into cash rather than run the risk of its value falling.
Diversification is also important. If you only invest in the shares of one company, the performance of your money is completely dependent on that company's fortunes. If it goes bust, you could lose the lot. By spreading your money across a number of different companies and investments, if one goes under you won't be as badly affected.
You may also want to mix up the types of investments you hold. There are four main asset classes: cash, which you can hold through your cash ISA; property; equities; and fixed interest. Witcombe explains why it's good to have a mix: "In 2011, equities performed badly, while the top performers were fixed-interest funds. It could be the other way round this year so it's worth having exposure to more than one asset class."
While it's possible to diversify your investments yourself, the easiest way to do this is through a collective investment.
As the name suggests, these are ready-made portfolios of investments with each unit or share you buy giving you exposure to all of the underlying investments. Depending on the collective investment, this could mean an instant portfolio of anything from 20 to 250 companies for an investment of as little as £50 in some cases.
The collective approach can also work out to be more cost-effective for investors with smaller pots. Even with a relatively concentrated portfolio of, say, 20 shares and a modest share dealing charge of £7.50, you'd rack up dealing charges of £150 to replicate a fund's portfolio yourself. Conversely, a fund would levy a charge of up to 5.5% of your investment to get the same exposure, which on an investment of £1,000 would equal a less costly £55.
There are two distinct types of collective investments - open-ended funds, which include unit trusts and open-ended investment companies (OEICS), and closed-ended funds, which include investment trusts.
Although both invest in the same way, there are important differences. While an open-ended fund can issue more units as demand increases, a closed-ended fund has a limited number of units. This means that as well as being influenced by the performance of the underlying shares, the price of a unit in a closed-ended fund will also be affected by supply and demand.
As an example, if you invest in a closed-ended fund, for instance an investment trust, and it performs strongly or is in a sector that is particularly attractive, demand for units will increase.
This will mean your investment is worth more than the value of the underlying assets. This is an advantage of closed-ended funds but, unfortunately, it can also work against you when a fund or sector falls out of favour. If this happens you could find the price dragged down, so the units are trading at a discount.
Whether you choose to invest in closed-ended or open-ended funds, you'll face a number of charges. As closed-ended funds are bought and sold through the stock exchange, you'll pay a dealing charge when you buy. This varies but many of the investment trust companies have arrangements, especially on their ISAs, where they pool all their investors' money to enable them to negotiate a discount on dealing costs.
Open-ended funds are more straightforward, but potentially more expensive. These have an initial charge, which could be anything up to 5.5%, and an annual charge of up to 2%.
BUILDING A PORTFOLIO
With so much choice available, it's important to have an idea of where you would like to invest. This will come down to your risk profile, which takes into account factors such as your time horizons and how you feel about your investments losing value.
For example, if you're saving for your retirement in 30 years' time you can afford to take plenty of risk as your investments will have ample time to recover from any losses. So you might want to consider spicing up your ISA with investments in emerging markets, smaller companies and specialist sectors such as technology and commodities.
But, whether you go high risk or invest in something more pedestrian such as fixed interest, while there may be plenty of funds to choose from, it isn't necessary to hold hundreds to get a well-diversified portfolio. If you're starting out with a stocks and shares ISA, one global fund may be sufficient. Then, as the value of your ISA grows, you can add more specialist funds to pep up your portfolio.
Once it's up and running, it's sensible to keep an eye on your ISA but, because stockmarkets fluctuate on a daily basis, it's best not to become obsessive about this. "Obsessively monitoring and adopting a strategy that involves a knee-jerk response to the 10 o'clock news will almost always result in investors losing money," warns Rebecca O'Keeffe, spokesperson for Interactive Investor.
"In addition, if you're constantly trading, unless you're underlying investment is large, the commission costs involved might well erode the benefits." A monthly check will usually suffice, with a more thorough annual review to rebalance your portfolio and ensure it's delivering the best possible performance.