Cash or Stocks and Shares - Which ISA is right for you?

May 2017
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According to figures provided by Royal London Asset Management £1,000 invested 10 years ago in a cash ISA would now be worth £900 after inflation is taken into account. The same amount invested in a stocks and shares ISA, 50% in shares and 50% in fixed interest, would now have £1,500 of spending power.

This simply reflects the fact that while cash ISA interest rates have fallen over that period from 6% to around 1%, the stock market and corporate bonds have provided growing returns well in excess of inflation.

Why then are 80% of the UK's ISA savings placed in cash ISAs?

When should an individual saver choose cash ISAs or stocks and shares ISAs?

The ISA allowance for over 18s is now £20,000 per tax year and is index linked each year. This may be split between cash and stocks and shares, in any proportion chosen by the saver.

It is also possible to transfer funds between these two types of ISA. This freedom to mix and match has been exercised by few savers who overwhelmingly favour cash investment, despite historically low interest rates.

The case against cash

Investing in cash deposits when interest rates are lower than inflation means slowly losing money each year. Even though the account balance appears to be growing, the nominal capital will have less spending power, once inflation is taken into account.

Since August 2016 when interest rates in the U.K. were cut and coincided with the sharp post-referendum devaluation of £ sterling, inflation has been on the rise and is now running at 2.7%. This means cash deposits are in effect falling in value. If the interest rate is say 1% and inflation is say 2% each year the cash savings are losing 1% of their value.

Recent increases in commodity and factory gate prices suggest that higher inflation may be here to stay for a while. Until interest rates go up and inflation starts to fall, cash ISAs are destined to slowly lose money year on year in real terms.

While stocks and shares ISAs may potentially outstrip inflation and dividends are on average currently 3 times higher than interest rates, this is not guaranteed and dividends and share prices could fall rapidly in the short term.

The case for cash

Those who have cash savings may consider the accessibility of cash and its relative stability to outweigh its gradual loss of purchasing power, especially if these savings are for short term needs. If for example, you are saving for a short term goal such as buying a car in the next 1 to 2 years or a deposit for a home which you expect to buy in under 5 years, then cash may be best as interest rates are a secondary consideration to accessibility.

However if your saving and time horizons are longer term, leaving your ISA savings in cash could leave you no better off, once inflation is taken into account, as price rises could wipe out the benefit of interest earned.

So if your time horizon for saving is longer than 5 years should you consider a stocks and shares ISA for some of your savings?

Both, not either or

The key to successful investing in any assets which may fall in value or like property become illiquid, is to only invest that part of your savings that will not be needed for spending in less than 5 years or longer. This means that you can time the cashing in, when in profit, rather than being forced to sell at a loss.
 
So saving in shares, fixed interest or property based ISAs should only commence after all short term needs are covered by accessible cash. First build up the cash you are likely to need for short term spending needs such as car replacement, holidays and larger capital spending, and a fund equivalent to say 6 months regular outgoings. Once you have achieved this, investing surplus savings in stocks and shares ISAs is likely to provide a better hedge against inflation over the medium to long term.

As you can hold both types of ISA and transfer funds from one to the other, it is ideal to check the balances of your accounts from time to time and switch in and out of cash and equities. This ensures that your shorter term needs are always covered by accessible cash.  Leaving you to safely ride the ups and downs of the stocks and shares ISA and have the prospect of greater longer term growth by not being forced to sell after share prices have fallen.

Kay Ingram
Director of Public Policy, LEBC

Please remember, no news or research item is a recommendation or advice to buy. LEBC Group Ltd is not responsible for accuracy and may not share the author’s views. If you are unsure of the suitability of any investment for your circumstances please contact an adviser. All investments can fall as well as rise in value so you could get back less than you invest. The Financial Conduct Authority does not regulate tax planning. Tax rates and allowances may change in future.

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