All too often the end of the tax year triggers a rush of last-minute investors racing to top up their ISAs in order to take full advantage of their ISA allowance. But putting money in an ISA at the end of the year potentially marks a year of tax-savings lost. Instead, maximise your tax efficiency and make the most of compound returns by putting money to work at the beginning of the tax year. The ISA allowance for 2013-2014 is £11,520, up to half of which can be in cash.
For many, ISAs represent the core of their portfolio; indeed, invest the full allowance each year and if you achieve an average annual return of 6.54% you’ll be a millionaire in 30 years’ time. That’s a long time horizon but it’s not unrealistic for anyone in their mid- to late thirties.
For others, ISAs are an additional investing tool that supplements their pension pot. While the pension (company, SIPP or other) is a closed box—you can’t access your assets until retirement—your ISA can be your ‘unlocked’ box as one of the perks of ISA wrappers is that assets can be withdrawn at relatively little notice. Though you don’t want to withdraw assets unnecessarily it’s comforting to know that you can if you need to.
There are numerous strategies for making the most of ISAs and pensions. Let’s investigate some of the most common strategies and some key points to consider for each.
My ISA Is My Pension
It may be that ISAs represent your only foray into the world of investing, in which case you want to ensure you build up a diversified portfolio with a solid core holding at the centre.
A diversified large-cap fund can often serve as a core stock holding in a portfolio. Knowing that your portfolio includes a rock-solid core can help you better cope with the extreme volatility that has plagued the market in recent years. Why large caps? Typically a core stock holding is a large-cap fund because the market is made up of mostly large-cap stocks. Given that small caps have outperformed large caps over very long time periods, a question that naturally arises is "Why does my portfolio have to look like the market with all those lacklustre large caps?" But large caps tend to be steadier over extended periods of time than smaller stocks, giving investors the courage to stick with them through the rough patches. In short, they tend to be solid businesses with steady profits that compound your money decently over time.
Other considerations when picking your core fund holding are fees, management and indexing. Firstly, although it may not seem like a big difference whether you're paying 0.5% or 1% as an expense ratio, fees cut into returns dramatically over time. If the stock market returned 5% in a year, a 1% fee would reduce that to 4% and that’s before you’ve considered inflation, which has historically run at around 3%, bringing your net return down to just 1%. It’s clear to see that every percentage point counts.
Secondly, if you’re picking an actively managed fund then look for an experienced manager with a strong track record.
Thirdly, consider an index fund such as a tracker or an ETF. These are generally low-cost—some ETFs offer fees close to zero, they virtually guarantee you the index’s return, and you won’t have to worry about management or strategy changes.
Keep in mind that diversifying means not only by market cap (small cap, mid cap, large cap) and sector (financials, energy stocks, consumer defensives, and so) but also, at a broader level, by assets (stocks, bonds, property, commodities, cash), by regions (developed world stocks and bonds, emerging/frontier market stocks and bonds) and even by security types (stocks, funds, ETFs, investments trusts).
My ISA Complements My Pension
Another scenario is one in which the ISA supplements the main investment vehicle, such as your pension. One example might be of a retiree with a pension who uses ISAs to reinvest income, take natural income, or make withdrawals if needed without impacting their tax status.
Starting the retirement phase of your life doesn’t mean you’re about to kick the bucket—in modern Western society on average you’ve got at least a decade ahead of you and in many cases up to three decades. So having a mixture of assets across your investments is important.
If, for example, you’re likely to live for another 20 years you still want to be partly geared towards equities or higher risk investments, as you still need some equity growth in your portfolio to keep the real value of your money ticking over. Once again, it’s important to keep in mind that inflation is on the rise as well as taxes so investors need to figure this into their portfolios.
My ISA Is My Icing on the Cake
Our third scenario is one in which you may be comfortable that you are suitably invested to achieve your goals but you still want to put any extra cash to work, ideally in a more ‘exciting’ fashion. In this case you may want to supplement your pension’s diversified and targeted portfolio by putting higher-risk and greater-potential investments in ISAs, where their income and gains will be tax free. If it’s excitement that you’re seeking and you want to run a ‘mad money’ account then an ISA can be a good way to limit your pot and ensure it’s kept separate from your nest egg.
Here at Morningstar we’re fans of investing (trying to put money where the odds of earning a good long-term return are stacked in one’s favour) rather than speculating (buying an asset in the hope of big short-term gains or making a call on the short-term direction of the market, individual stocks, or commodity prices). But if you must gamble, then be sure to Speculate Without Losing Your Shirt.
By no means is this an exhaustive list, but having the flexibility of ISAs alongside the benefits of having money locked away in a pension is a good target place to be—these wrappers complement one another.
In all cases, if you are running two portfolios side by side make sure you’re looking at the big picture. Use Morningstar.co.uk's Instant X-Ray tool to identify any stock overlap, review your overall asset allocation, and see which areas of the market you may have above-average exposure to.
