Speculation about the fate of the cash ISA allowance has revived the debate about the merits of using a stocks and shares ISA to put your money to work in the financial markets.

Regardless of whether the Government follows through on a reported plan to limit contributions to a cash ISA to £4,000, there is a strong argument for considering turning to the markets through a stocks and shares ISA as long as you have five years or more to leave your cash to grow.

The Barclays Equity Gilt Study is the main reference point for returns from the UK market. The latest edition, out in April 2024, revealed that over the preceding 20 years, the real, or inflation-adjusted, return from cash was -1.8% compared with 3.1% from equities. Demonstrating that investing your money has historically been much more likely to protect you from the impact of rising prices than cash in the bank.

A stocks and shares ISA is the perfect place to grow the value of your investments given any returns are kept safely away from the clutches of HMRC.

In this article we will take you step by step through the process, from choosing the right ISA type for you, the mechanics of setting up an account and examining how to populate it with a diversified portfolio of investments, before touching on how you should think about managing your holdings going forward.

While aimed at those who are at the outset of their investing journey, the insights which follow could still be useful to existing ISA investors who want to bring some order to an investment pot that might have got into a bit of a jumble, for example, or someone whose participation in the markets has stalled for whatever reason but who now wants get back in the investing habit.

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‘Over 20 years UK stocks have delivered 3.1% a year adjusted for inflation compared with -1.8% for cash’

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STEP 1: CHOOSING THE RIGHT TYPE OF ISA

Introduced in 1999, the tax-efficient ISA wrapper has several guises and different types of ISA will suit different types of savers and investors.

The most compelling feature of an ISA is tax efficiency says Wesley Harrison, head of financial planning at Benchmark Capital, a subsidiary of Schroders.

‘You can benefit from tax-free growth on income and no capital gains, that is the biggest selling point for us [and that’s what we tell our clients],’ says Harrison.

This point on income is worth remembering outside of an ISA if you receive more than £500 in dividend income from shares you would pay tax on it, within the tax wrapper you don’t.

There are five different categories of ISA:

1. JUNIOR ISA 

2. CASH ISA

3. STOCKS AND SHARES ISA

4. LIFETIME ISA 

5. INNOVATIVE FINANCE ISA 

ISAs are portable, so it is possible to take your ISA with you to a different platform or provider and to combine multiple existing ISAs (as long as they aren’t different types) into a single account. You can only pay into one Lifetime ISA in each tax year and a child can only have one Junior ISA of each type(cash and stocks and shares). The overall annual ISA limit for an adult is £20,000. 

KEY FEATURES OF THE DIFFERENT ACCOUNTS

A Junior ISA, Lifetime ISA or stocks and shares ISA will enable you to invest in UK and overseas stocks, funds, investment trusts and exchange-traded funds.

Each ISA has different features. The Lifetime ISA, for example, can help get on the housing ladder or fund your retirement. 

You can invest up to £4,000 every tax year until you’re 50. The Lifetime ISA limit of £4,000 counts towards your annual ISA limit. 

You need to be 18-39 to open an account and make your first payment before you’re 40. 

The government will add 25% bonus to your savings up to a maximum of £1,000 per year. You can withdraw money from your Lifetime ISA if you’re buying your first home, aged 60 or over or terminally ill, with less than 12 months to live. In any other circumstances you would face onerous withdrawal charges.

A Junior ISA can help you save for your child’s future until they turn 18. You can invest up to £9,000 each tax year for your child. They can access the cash when they turn 18 – not before. Parents and guardians can open a Junior ISA, but anyone can pay into them. [SG]

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TOP TIPS FOR ISA INVESTORS

USE IT OR LOSE IT

Benchmark Capital’s Harrison says one of the biggest mistakes people make is not using their tax-free ISA allowance and leaving it too late (like towards the end of the tax year) before they save and invest. 

He says: ‘If you do this, you have potentially missed out on a full year of compounded returns.’

KEEP TRACK OF YOUR ISAS

Some of Harrison’s clients have lost track of the number of ISA accounts they have opened during the tax year, and they end up contributing to too many and going over the limit. So don’t forget how many ISAs you have and keep track of your ISA investments. 

MANAGE YOUR ISAS

If you are going to be using ISAs for investment, don’t think in the short-term, but have a long-term view, says Harrison. 

Some clients incorporate their ISAs as part of their retirement planning and generate an income from their ISA products.

Make sure you are properly diversified, monitoring and rebalancing your ISA or ISAs.

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STEP 2: OPENING AND FUNDING AN ACCOUNT

So, you have established your financial goals, have some money to put to work in the markets and familiarised yourself with the ISA rules. You are all out of excuses and it is time to take the leap and open your stocks and shares ISA. The good news is the process is painless. Filling in the application with your ISA provider should take 10 minutes or so.

In order to open your account, you’ll need your name, address and mobile phone number, as well as your date of birth and national insurance number. You’ll also need to punch in your debit card details if you are making a lump sum payment and your bank account details if you are making a regular payment by direct debit.

Next, you’ll also need to fund your account to access the exciting universe of investments including bonds, shares, funds, investment trusts, and ETFs.

You can use your ISA allowance by funding one lump sum, or in smaller amounts. The minimum lump sum investment for an ISA is £500, and you can top it up again later. But remember to stay within the annual ISA allowance, which for the 2024/25 tax year is £20,000. The regular investment service from Shares parent AJ Bell lets you invest as little as £25 a month.

With AJ Bell’s stocks and shares ISA, you can instantly pay money into your account by logging in and selecting the ‘Single payment’ option. Another way to fund your account is by making regular payments by direct debit from your nominated bank account. To set this up, log in and select ‘Regular payments’.

One of the advantages of saving regularly into your ISA, rather than periodically investing big one-off lump sums, is this can help insulate you from stock market fluctuations through a phenomenon known as ‘pound-cost averaging’. By buying shares or fund units with a regular payment, you buy more shares or units in months when their prices are lower than when their prices are higher. As prices move up and down, your investment return is ‘smoothed out’.

With the AJ Bell platform, buying selling investments really couldn’t be simpler. Just log in to your account and from the ‘My account’ menu, click on ‘Buy and sell’, which takes you to the screen where you can choose which investments you want to trade. For shares and other listed entities like ETFs and trusts, you can only place a direct deal during market hours. In the UK these are 8am to 4.30pm. For funds, you can buy or sell outside market hours, although your deal won’t be executed until the next valuation point, which is usually the next business day. [JC]

STEP 3: CHOOSING YOUR INVESTMENTS

Investing can appear daunting, but like any long-term endeavour, breaking the task down into baby steps makes the whole process easier to undertake.

A stocks and shares ISA is a tax efficient way to invest in the stock market and other asset classes like bonds, property, infrastructure, renewables and commodities.

But just because all these choices exist does not mean they are appropriate for everyone.

Think of it like a restaurant menu. Instead of looking at the names of the meals, we can break the menu down by the essential ‘macro nutrients’ of proteins, fats and carbohydrates.

Achieving a good balance between these essential nutrients is important for general physical health.

Investing is all about managing risk, and each asset class has a different risk profile and return expectation. Just like a pursuing an individually balanced diet, investors should aim to achieve a balance of investment risks which reflect their personal circumstances and investment goals.

Essentially there are three broad buckets of risk. Equities are the riskiest asset class, government bonds (a type of government IOU) are lower risk than stocks and cash is the lowest risk asset.

What do we mean by risk? Well, think about risk as the ‘lumpiness’ of returns. In any single year stocks can go up or down in value a lot more than bonds while cash always delivers a steady positive, but relatively low rate of return.

That deals with risk but what about returns? Well, over the long run stocks have provided investors with the highest investment returns, while bonds and cash have delivered the lowest returns.

While it is important to understand that stocks can fall in value from time to time, the longer they are held, the more likely they are to provide a positive return. This is due to growth in corporate profits which has averaged between 6% and 7% a year.

The annual Barclay’s Equity Gilt study demonstrates that over the last 100 years, there has never been a decade which resulted in negative returns from owning UK stocks. This does not mean it can never happen, but the chances are slim.

PASSIVE OR ACTIVE?

Now we have a better idea of the risks and returns from investing across different assets, the next question is to decide whether to self-manage your investments or outsource it to a financial advisor.

It is worth pointing out that even if you decide to manage your own investment portfolio, it may still be worthwhile speaking with a professional financial advisor.

Assuming you take full control, the next step is to decide whether you want to track broad indices like the S&P 500, FTSE All-Share or MSCI World index, or to actively manage your portfolio.

Higher returns can be made through active management, but even professional fund managers find it hard to consistently beat the indices over the long run.

Picking successful fund managers can be just as difficult to get right as picking the right stocks. There are no right or wrong approaches, it just comes down to personal preference and temperament.

Investing through active or passive funds provides instant diversification which is a big advantage for investors starting out.

Active funds are more expensive than passive funds, and minimising costs is an important consideration in investing. The upside is that successful funds can deliver superior returns to the benchmark over time, but remember, they may also lag.

Some investors may decide to build their own portfolios by choosing which stocks to hold. It saves paying fund fees, but it also requires a certain amount of capital to achieve diversification and investment knowledge.

A minimum of 25 to 30 stocks is required to achieve a reasonable level of diversification. Therefore, it can make sense for investors starting out to use ETFs to achieve core diversification, then consider adding individual stocks to the portfolio later, if desired.

This is a called a passive core, active satellite approach to managing investments and was used by an investment firm I worked for many years ago to good effect.

HOW MUCH TO PUT INTO EACH RISK BUCKET?

Individual risk appetite should drive asset allocation and in general, younger investors with a longer investment horizon, and investors with a higher risk appetite can afford to allocate a higher proportion to stocks.

To some extent this decision can be outsourced to a one-stop shop which takes care of asset allocation by adopting a multi-asset strategy. For example, the Alliance Witan trust (ALW) is designed to be a core investment with a focus on long-term capital growth and a rising dividend.

Another option in this category is F&C Investment trust (FCIT) which also invests in private equities. Remember, asset allocation is decided by the manager, which means, it may not be suitable for everyone.

Another way to achieve diversification at a competitive cost is to consider starter or ready-made portfolios, which are available on most investment platforms.

The platforms typically ask you to select an investment goal, such as growth or income, and your level of risk, which might be conservative, balanced or adventurous.

You’re then directed to a ready-made portfolio that contains a mixture of actively managed funds or ETFs designed to meet the required risk level. Although from this starting point you would then be expected to manage the investments yourself.

STARTER ISA PORTFOLIO WITH ETFs

Exchange traded funds are primarily passive vehicles which track an index, although increasingly actively managed ETFs are becoming available.

Passive ETFs track major indices like the S&P 500 index and benefit from low costs and good liquidity. They trade like individual stocks, unlike funds which trade once a day or weekly.

Let’s look at two different types of investors, Jane and Sharon, to discover how their portfolios might differ due to their risk appetite.

Jane is in her mid-20s, lives with her parents and works at a software company. Jane considers herself risk tolerant and comfortable dealing with the ups and downs of the stock market and because she has modest outgoings she can put significant sums to work as she looks to build up money to buy her first home.

Sharon is in her late 30s and married with two teenage children. She is working part time and has a more cautious approach to investment risk and has a more modest amount of available cash to invest. [MG]

STEP 4: MAINTAINING YOUR PORTFOLIO

Now you’ve got your ISA up and running you’ll want to keep on top of it to make sure it continues to meet your needs. This may sound like one big headache, but you can keep things relatively stress-free by following a few simple steps.

1

First, work out where you are in relation to your investment goals. If you’re investing for the long term, more than 10 years say, you may be able to tolerate more risk and benefit from higher potential returns. If you’re investing over a shorter period, a greater focus on preserving your capital and minimising risk may be more appropriate.

2

Second, consider contributing regularly to your ISA from your normal income, which can be easily done by setting up a monthly direct debit from your bank. This means you’ll be constantly building your tax efficient savings without having to remember to do it. As your funds build up, you can invest larger chunks of savings in fewer trades, keeping your costs to a minimum.

3

Whichever ISA you choose, maintaining diversification in your portfolio is an important part of sensible financial planning. Diversification means spreading your investments across different types of assets (stocks, funds, bonds, gold etc) and sectors (US, UK, tech, property, income etc) to reduce the impact of market volatility. By rebalancing your portfolio, say annually, you can make sure your holdings remain appropriate for your circumstances.

Say for example you have a portfolio comprised of 60% stocks, 40% bonds (whether directly or through funds), and the stocks do well while the return from the bonds goes down.

In this case, the value of the various holdings in your portfolio will change and may now look more like 70% shares, 30% bonds.

The concept of portfolio rebalancing is that you then take your profit on the shares that have done well and buy bonds that haven’t done as well for the time being, until the stocks part of your portfolio makes up 60% again.

This helps to keep a more consistent level of risk exposure and also encourages the discipline of selling assets that have appreciated and buying those that may have become relatively undervalued.

4

Remember time in the markets beats timing the markets. It’s notoriously tricky to accurately time the markets and buy at exactly the right time, and even the professionals struggle to do it consistently.

What history shows is that time is your friend when it comes to investing, and the longer you leave your money invested, the better chance you have of getting superior returns. It is also the case that missing just a handful of the best days for the market can seriously undermine your long-term returns, and often the best days follow market corrections.

5

Finally, five, and perhaps most crucial, it’s OK to mostly do nothing. Markets have shown time and again that they can bounce back from the greatest of blows far quicker than you might think. The UK’s FTSE 100 Index took less than two years to recover all its Covid pandemic losses, while the US S&P 500 Index took barely six months.

Investors are frequently tempted to do something in response to bad news, be it a poor set of company results, ugly economic figures, geopolitical volatility, or simply a year of poor returns. It is often exactly the wrong thing to do, which is why you should avoid checking up on your portfolio too often. If your personal circumstances have altered, or the original investment case of a holding has changed, by all means act, but otherwise, trust yourself, relax, and let time in the markets demonstrate its true wealth-generating power. [SF]

AJ Bell referenced in this article owns Shares magazine. The editor (Tom Sieber) and authors of this article (James Crux, Sabuhi Gard, Martin Gamble, Steven Frazer) own shares in AJ Bell.

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