Maximising your annual allowance can enable you to generate significant returns
WITH the end of another tax year fast approaching, there is still time to invest up to £11,280 (or £5,640 in cash) in an individual savings account (Isa). If the prospect of sheltering your hard-earned cash in a tax-free wrapper – for higher rate taxpayers, this means avoiding income tax at 40 per cent on any interest – isn’t incentive enough, it may be time to look to the plethora of Isa millionaires cropping up across the country. Brewin Dolphin has 18 investors who hold at least £1m within the Isa wrapper; and Barclays has seen its number double in the past year. These are extreme examples, but Isas are excellent engines for growth.
The more risk you take, the greater the potential for bigger reward. What’s more, the combination of high inflation and low interest rates means savings in a cash Isa will be eroded over time. But cash still offers flexibility, and for those wanting rainy day money, or with a very short time horizon, a cash Isa (where at least any interest is protected from tax) is a sensible option. But Isa millionaires have not amassed their small fortunes by investing in cash. And those with a lower risk appetite should bear in mind that, historically, stocks and shares have outperformed other asset classes. Furthermore, savers can put twice as much in a stocks and shares Isa, and the more money you have in the market, the more you are set to gain.
If you do choose a stocks and shares Isa, diversification reduces risk, but it also reduces the potential for big returns. You will inevitably tread a middle path between the best and worst performers. The Isa millionaires who have punted all their money in one or two companies have seen their gamble pay off. But being exposed in only a small number of shares can potentially damage your performance, and investors need to remember that clawing back from losses is a lengthy process. “If you lose 50 per cent of the value of your investment, you need to increase by 100 per cent just to get back to where you started,” says Tom Stevenson of Fidelity.
SLOW AND STEADY WINS THE RACE
For every gambling Isa millionaire, there are dozens more investors who have had their fingers burnt by having a very concentrated portfolio. But it’s still possible to become an Isa millionaire while viewing your Isa as a long-term planning tool. Recent Fidelity data found that, assuming the full Isa allowance is used from April 2013, and with an annual growth rate of 5 per cent, if you start investing aged 30, you would hold £1,011,955 by the age of 60.
The figures show that a simple combination of compounding and time in the market could be enough to help investors get extremely good returns, even to the extent of becoming an Isa millionaire. It’s not impossible. The South East Asia Fund, for instance, was launched in 1984 and has grown at 13 per cent per year since. Compounded, it’s a substantial return.
The trick is to invest a decent sum consistently and over a long period of time. It also means using a mixture of asset classes, and exploiting the benefits of both reinvested dividends and dividend growth to boost the performance of investments. The benefits of compounding – described by Chris Davies of Fidelity as the “foundation of investment success” – can be maximised by getting your money in the market as early as possible.
The best opportunities usually lie in the areas where the outlook seems most difficult: “such is the contrarian nature of markets,” says Stevenson. Making big investments when fear is greatest will help top up returns, but like the Isa millionaires, you will have to back your judgment and avoid selling out of investments prematurely. Darius McDermott of Chelsea Financial Services says investors should look to Asia, where Asian currencies “will appreciate against sterling over time – helping with returns for investors in overseas equities”. If your risk appetite doesn’t extend that far, there are European companies, like Siemens or Unilever, that have exposure in those countries.
Using an actively-managed fund – which enables investors to gain exposure to a range of sectors or regions as selected by a fund manager – will suit some investors. Not all active managers will outperform the market, but “you can be certain a passive fund will under-perform the market to the extent of the charges on the fund,” says Stevenson. But while some Isa millionaires will self-manage their investments, the experts advise this should only apply for sophisticated investors with time on their hands and a very keen interest in stocks. And bear in mind that, since 1987, “there will undoubtedly be stocks that have gone in and out of fashion, and timing that is extremely difficult,” says McDermott.
Most Isa investors won’t become millionaires. But, given that the Isa’s precursor – the Private Equity Plan – was created over 25 years ago, and we are only seeing Isa millionaires crop up now, the safer bet of duration and length of investment could see you make significant returns.