| Real Life Strategies for Building Wealth

One question my readers seem to ask me regularly is whether ISAs are a good investment. Here I’d tell you why I  believe  ISAs are one of the best investments around and how you can select the ISA for you.

But let me tell you a story first.

The other day, I met and old friend of mine and, as often happens these days, our conversation over coffee turned to retirement dreams and the provisions we have made. (There was time when we didn’t talk about retirement and minor maladies but about nights spent partying and career ambitions. Oh well…). I mentioned my stocks and shares ISA with Nutmeg, proud that I maxed it out and hopeful that it is the foundation to a more secure future.

“But why are you doing this?” – my friend asked. “I didn’t put much in my ISA last year. The interest rates are so low now that it hardly matters whether you keep your cash in a savings account, under the mattress or in an ISA, right.”

Wrong. Contributing to an ISA, and maxing it out when the opportunity is there, is still very much worth it. It is worth contributing even to a cash ISA though the interest this will bring is on the low side. According to Money Week, the best interest rate on a cash ISA today is 1.95% with building society Principality’s five-year bond and this is branch based and available only if you live in Wales or the Welsh borders. The next best is Paragon Bank’s five-year bond paying 1.75% which is online only. You get the picture.

Despite the low interest rates, cash ISA can be a great saving vehicle.

Now let’s talk about stocks and shares ISAs.

Here are four features that make stocks and shares ISAs a good investment:

#1. Stocks and shares ISAs are a good investment because they are very tax efficient. You know that profit from investments is taxed, right? Well, if you keep your ISA contribution within the tax-free ISA limit (for 2017-2018 this has gone up to £20,000 in case you didn’t know) you won’t pay any tax. This is how ISAs are ‘tax-free’ (remember though that the Government has already taken its cut because you contribute after tax income).

#2. Stocks and shares ISAs are very flexible. This is most easily understood by imagining your investment as a delicious piece of chocolate and the ISA as the rapper around it. You can do two things:

  1. Blend the chocolate and rap it in an ISA. This means that you can select the kind of investments that you can ‘rap’ in an ISA. There are some rules about what kind of investments are allowed but most stocks and shares play. (You are in full charge of selecting, rebalancing etc. your portfolio though it is in an ISA.)
  2. Get a Lindt Dark Chocolate (or another variety you like) that is already rapped. This is the case when you start stocks and shares ISA with a specialised provider and they look after your portfolio for you. You still have to let them know some of your preferences. (An example here will be the Nutmeg ISA; or Scalable Capital ISA.)

#3. Stocks and shares ISAs can start you investing. Okay, to be more specific, the ‘off the shelf’ stocks and shares ISA could start you investing because they take away some of the responsibility for selecting stocks and, through this, some of the paralysing fear of making a mistake. These ISAs also make investing a ‘low entry’ activity since you don’t really need to know much about the technicalities of investing to dip in.

#4. Stocks and shares ISAs are ‘untouchable’. Do you find that you do this on going moving of money between your savings account and your current account? (For my readers in the US ‘checking’ account.) So do I. And do you know why I do it? Because I can always replace the money in my savings account. Guess what? ISAs are not like that. Whatever happens you cannot put in it more than the yearly amount (tax free). As a result, I’ve never ever taken a single penny out of my ISA. This is why I say that ISAs are ‘untouchable’ (and this is exactly as it should be).

Four rules to select the ISA for you

Now that I hope to have convinced you that ISAs are a good investment, particularly stocks and shares ISAs, let me tell you the four things I believe you should consider to select the one for you.

These are not something that I’ve plucked out of thin air. Quite the reverse; these are the four rules that according to Tony Roberts (in his book Unshakable) ensure that our investments are sound without being overly conservative.

Rule 1: Risk awareness or what is the potential loss?

Before you go and open a stocks and shares ISA (never mind the provider) you have to be aware that it is extremely unlikely it will only make profits. There will be times when the value of your ISA (your investment) will go down.

You also need to be aware that I’m not talking about your ISA going a little bit down. Research shows that at least once per year there are dips of 10% or more. Scary stuff, uh?

Well, not really. Despite these steep drops most years the stock market recovers and finishes up (there are very few exceptions).

Apart from that, roughly every three-four years we experience what is known as ‘bear’ market. This is when the stock market drops by 40% or more. This is real scary…in the short run. Again, research shows that the market always recovers and over-recovers; but it may take couple of years or so.

Your ISA doesn’t have to behave so erratically but this will depend some of the things we’ll discuss later. What is important is that you know that dips are normal so that you can ‘sit them out’. The worse thing for you and your ISA would be to pull out of it during a dip.

Rule 2: Profit awareness or what is the potential return?

Profit awareness when selecting an ISA is important but not that easy to judge. One thing you could do – when opening an “off the shelf” stocks and shares ISA – is to look at the returns that the provider has achieved historically.

Not perfect but still something.

Rule 3: Tax/fee awareness or what tax and charges you have to pay?

Taxes and fees can obliterate your earned interest; when compounded it gets really scary.

When you select the ISA for you, please make sure that you understand all fees and taxes you’d incur. Remember when I told you that one of the best things about ISAs, is that they are tax-free?

True. You still need to watch these fees. Some managed ISAs can have rather steep fees and even digital wealth managers divide their fees in several categories.

Remember: the lower the fee, the more likely it is that your ISA is a good investment.

Rule 4: Diversity awareness or how diversified is your ISA?

Any investor, even a beginner, knows that diversification reduces risk (there are caveats but we won’t get into these now).

When selecting an ISA you should make sure that it is diversified across:

  1. Financial instruments: your ISA is a portfolio that can contain equities, bonds, real estate funds, commodities and cash. Usually the proportions would depend on your risk tolerance and the type of market.
  2. Industrial sectors. Having a stocks and shares portfolio of companies from one sector is risky.
  3. Location. Experience shows that the stock market rarely collapses globally at the same time. This means that if you own only UK companies (or US companies) you are exposed to rather severe drops in value. Owning shares in companies in different countries can lower the drop substantially.

The ideal stocks and shares ISA formula:

Ideal ISA = (Relatively) low risk + high (potential) returns + low fees + high diversity

I have to tell you, friends, that my Nutmeg stocks and shares ISA seems to be ideal; particularly given that it is also very low maintenance because it is fully managed by the Nutmeg team.

How does you ISA score on the ideal ISA formula? (If your ISA doesn’t match the ideal formula it may be time for you to start looking around.)

photo credit: BPPrice eggs via photopin (license)