Cash ISAs can still make prove worthwhile despite the miserly rates on offer, but Stocks & Shares ISAs could likely outperform them over time.
It’s always the biggest dilemma when it comes to investing your annual Individual Savings Account allowance: should you opt for a Cash ISA or a Stocks & Shares ISA?
The key issue is that they are both very different products.
They might come under the same broad ISA umbrella, but they are certainly not the same type of investment.
Pros and cons of a Cash ISA
They are very straightforward. You invest your money and the provider – often a bank or building society – will tell you how much interest you’ll receive.
Every bit of interest you earn will be totally tax-free and you’ll be able to get your hands on your money whenever it’s needed.
And if your provider hits a problem and goes bust, you will be protected up to £85,000 under the Financial Services Compensation Scheme.
However, the obvious downside with Cash ISAs is that the interest rates aren't great and don't match inflation, so your savings are losing value. Of course, there are a number of Cash ISAs that require you to tie up your money for set periods – say one or two years – in exchange for a slightly higher rate of interest.
For more on Cash ISAs, read our guide.
Pros and cons of a Stocks & Shares ISA
You have the potential to earn substantially more than you would in a Cash ISA.
However, returns are not guaranteed so you may even end up losing everything you’ve invested.
What’s more, while your investments are protected should your provider go bust, the protection limit of £50,000 is lower than that of a Cash ISA.
This ISA tax wrapper can be placed around a wide range of investment products, such as unit trusts, exchanged traded funds and individual stocks and shares.
This means you are free to invest pretty much anywhere and everywhere you like – safe in the knowledge that earnings will be shielded from the taxman.
The downside is you need to do plenty of homework to decide on what exposure you’re after and which provider is offering the best arrangement.
For example, the costs levied will vary enormously and your overall portfolio will need to be making returns comfortably in excess of the charges for you to enjoy a profit.
To read more about investing and Stocks and Shares ISAs, click here.
Which one is best?
It’s impossible to say as both have their attractions, according to Alex Neilson, investment manager at Investec Click & Invest.
“In an ideal world, you’d have different ISAs for different purposes,” he said. “A lot depends on whether you’ll need the money in the near future.”
He believes anyone wanting to get their hands on it over the next three to five years should stick to a Cash ISA.
“If you have a future expense coming up, such as building an extension to your house or paying for a holiday, then a Cash ISA makes more sense,” he explained.
“Although the interest you’ll earn is minimal, the chances of losing it are almost zero.”
However, Neilson pointed out that, on average, the best rate for an easy access Cash ISA was less than the rate of inflation.
“If the cash you hold in savings doesn't grow at a rate at least equal to inflation then the real value of those savings is eroded as the cost of living increases,” he explained.
Stocks and shares ISAs can have far healthier returns, although these are not guaranteed.
“If you’re saving for retirement and are 30 or 40 years old, you’ve got at least 20 years,” Alex added. “Over that timescale, the returns from the stock market will outweigh the risks of losing money in the short term.”
You can also reduce your risk through the way in which you invest in a Stocks & Shares ISA, according to Patrick Connolly, a certified financial planner with Chase de Vere.
He highlights the benefits of investing monthly premiums in order to negate the risks of market timing in a process known as pound cost averaging.
“If the stock market falls you will simply buy at a lower price the following month, reducing your average purchasing costs,” he explained.
“For those making regular investments, short-term falls can be very good news, as long as you’re patient and the investments recover.”
Other factors to consider
Investors tend to focus on how much risk they feel comfortable taking but this may be misplaced, according to Martin Bamford, managing director of financial planners Informed Choice.
“More important is the amount of risk an investor needs to take to achieve their financial goals and how much risk they are able to take, which is their capacity for risk,” he said.
He believes the choice between a Cash ISA and Stocks & Shares ISA should be taken in the context of overall financial planning.
“It’s about choosing the right vehicle that takes you a step closer towards achieving your goals in life,” he explained.
Which one is right for you will depend on your individual circumstances, whether you need the money over the short term and the aforementioned capacity for risk.
“Cautious investors need to choose whether to accept the real terms erosion of capital within a cash ISA or risk losing capital due to market volatility within a stocks and shares ISA,” he added.
“It really isn’t an easy decision to make.”
Of course, just because a Cash ISA suits your needs right now doesn’t mean it will always be a better option than a Stocks & Shares ISA – and vice versa.
It’s really important not to make investment decisions based on short-term sentiment or hype.
Many have done so in the past and lived to regret it.
Make the best decision for you today – and revisit regularly to ensure that your current choice of investments still meets your needs.
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