The risks of investing your ISA

Thinking of taking the plunge into the stock market for the first time with your ISA? Here's everything you need to know about the risks involved.

We’ve been writing an awful lot about ISAs lately, with ISA season really heating up. Indeed, the rates on offer this year are a significant improvement on last year - you can even Earn 5% on your savings, tax-free!

Cash ISAs

But now I want to look at the topic from a slightly different angle, and talk about the risks of investing in an ISA.

First of all, we should look at the difference between cash ISAs and stocks and shares ISAs from a risk perspective.  

Cash ISAs are no more or less risky than ordinary taxable savings accounts. Your savings are totally safe as long as the bank or building society you choose doesn’t run into trouble. Even then you’ll be protected by the Financial Services Compensation Scheme (FSCS) in the event that the bank collapses, and you suffer financial loss as a result.  

But there’s an upper limit on the amount of compensation you could receive. The first £85,000 of deposits - which includes money in Cash ISAs - per authorised institution, is protected. So you can reduce this risk by spreading your savings so you never exceed the limit with one institution. This will ensure all your money is protected if any of your ISA providers go bust.  

There’s also a danger that the rate on your ISA may fall behind the competition over time. But you can easily solve this problem by transferring your account to the new market leader whenever it becomes necessary. Find out more about ISA transfers by reading Move to a better ISA today!  

Stocks and shares ISAs

Like cash ISAs, the compensation limits for stocks and shares ISAs were upgraded earlier in the year so that a maximum of £50,000 of your investment is also protected if your ISA provider goes into default.  

But it’s a completely different ball game when it comes to the risks associated with the assets held inside your stocks and shares ISA wrapper. If you hold shares directly in your ISA, or you use it to buy one or more investment funds, and they perform badly, the FSCS provides no protection whatsoever.  

Is a stocks and shares ISA for me?

Of course, this is the nature of investing which involves taking a gamble on share prices which may, or may not, pay off. Investment risk is certainly something you should think carefully about before you take the plunge, but you shouldn’t necessarily let it put you off.  

It’s all about your attitude to risk. If the idea of putting money on the stock market is likely to give you sleepless nights, then you can probably conclude it’s not your cup of tea. Any investment you make should also be long-term and held for a minimum of five to ten years. ISAs are definitely not about timing the market.  

How can I reduce the risk?

If you fancy the potential for better returns by taking a greater risk, then a stocks and shares ISA might be a good choice. And, of course there are plenty of ways you can limit your exposure to investment risk.  

One way is to ensure your investment is well balanced and not too highly concentrated on one particular share or asset. You can achieve this quite easily by investing your ISA in an index-tracking fund.  

An index tracker aims to mirror the performance of a share index by investing in all the company shares quoted on it. For example, a FTSE 100 index-tracker will invest in all the top 100 UK firms. If the FTSE rises by 5% then the value of your ISA will increase by a similar amount. But the opposite can also happen if the FTSE falls.  

You can spread your investment risk even further by choosing a tracker which tracks the FTSE All Share Index. This provides exposure to hundreds of different company shares and covers around 98% of the UK stock market. You may also want to choose some global trackers too which enable you to invest in markets around the world.  

Diversify your ISA portfolio

If you prefer to be a bit more adventurous than trackers, you can build your own ISA portfolio by choosing managed investment funds (or investing in shares directly if you’re an experienced investor). Just remember, whatever you do, make sure your ISA is very well diversified.  

There are literally thousands of managed funds on offer so you can easily spread your risks. You could choose a selection of funds which give you exposure to overseas markets as well as the UK, and combine mature with emerging markets. You may also want to think about mixing small, mid and large companies and include different investment sectors in your portfolio.

Don’t forget, if you go for a very concentrated fund - such as one which invests solely in gold or property shares, for example - it will far more risky and volatile than a tracker.  

Think about multi-assets

You could also consider investing in other assets such as fixed interest - including gilts and corporate bonds - and commercial property as well as shares. You can hold these assets by picking funds which invest in these specific areas, or through multi-asset funds.  

Different assets often have little correlation which means they’re an effective hedge against each other. Putting it another way, commercial property and shares have a low correlation so when one is experiencing a poor run the other is likely to be enjoying stronger growth, which could help to offset your losses.  

Of course, there are no guarantees that any blend of funds will perform well. But mixing and matching is an effective way to manage investment risk.  

What do you think? Tell us your thoughts on ISA risks and good ISA investment strategies using the comments box below! Or head over to Q&A if you've got a burning question we haven't covered.

This is a lovemoney.com classic article, originally published in April 2010 and updated

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