Different ISAs for different people

Suppose you are 60, suppose you are 25. Suppose you are putting together an ISA. What you do doesn’t just depend on your age.

Article updated: 5 February 2019 10:00am Author: Michael Baxter

Different people need different ISAs, but it often seems to me that what advisors refer to as your ‘risk profile’ is misleading. The view that investing is high risk is not necessarily true, indeed investing can be low risk, but very profitable if you follow certain guidelines.

For me, what matters is why and when you are investing.

Not so risky in the long run

The data is unequivocal, in the long term, a diverse portfolio invested in equities, outperforms cash, and indeed just about outperforms all asset types — perhaps with the odd niche exception.

The only serious rival to equities is a leveraged portfolio of buy-to-let properties. But the key here is that word ‘leverage’. Sure, a buy-to-let portfolio in which you maintain your percentage leverage can perform extremely well in the long term, but there are two snags. Number one: leverage is risky, just as leverage can magnify growth in house prices, creating spectacular growth, it can magnify falls in house prices creating spectacular losses. Number two: changes in the tax treatment of interest on debt from buy-to-let has significantly reduced the level of leverage that is viable.

Bear in mind, that while the tax treatment of buy-to-let can work against you, ISAs pay out dividends and capital gains which are free of tax.

But for me, equity holds another benefit over property. Equities are an important part of the ‘investment leads to a bigger economy’ equation. Equities are good for the economy. Rising house prices merely distribute wealth.

Cash

What about cash? In the long run, holding your portfolio in cash is risky; inflation can erode its true value.

In my view, for an investor focused on the long run, the main benefit of cash is that it provides you with the means of benefiting from buying opportunities. The best time to buy is after shares have crashed. In a bull market, in which equities have been growing for several years in a row, then holding some of your portfolio in cash makes sense.

An investor focussed on a much shorter time horizon needs a different approach to cash. Indeed, in the short term, say looking at a time frame over three years, maybe a tad longer, equities can be risky.

Boils down to volatility

Actually, the key risk related to equities is volatility. Their price goes up and down. In the long run, history shows that the rises are worth more than the falls. But in the short run an investor may get unstuck. If you had bought just before the 1987, 2000 or 2008 crashes, you would have suffered a big loss. But you would have recovered your money eventually. The 1987 crash was followed by swift recovery. It took almost one and a half decades before the FTSE 100 passed the record set on December 30th 1999. The recovery from the 2008 crash took just over half a decade.

But don’t forget dividends. It may have taken almost 15 years before the FTSE 100 passed the 1999 level, but even a portfolio that had been formed the day before the index peaked in 1999, would have afforded investors a reasonable return over those fifteen years, once you factor in dividends.

Diversification over time

The key to reducing risk lies with diversification, but not just diversification over equities. Diversification over time matters too.

This takes me to another reason to hold cash. If you have a lump sum to invest, and you are hoping this lump sum will fund your retirement in say 15 years time, providing it can grow in value, then I think it would be risky to put all your money into equities on day one, as you maybe unlucky and invest just at that point when equities are close to crashing. But if you drip feed your lump sum into equities over say three or four years, you mitigate against this risk. Of course, you could be unlucky, and miss out from gains, but that is the psychology of the gambler — of course a risky approach to investing could secure better growth, but it could create losses too.

But most investors don’t have a lump sum. Instead, they invest from income, maybe a set amount each month. Such investors are by default, diversifying over time, cash becomes less important, in such circumstances.

Reason for investing

Let me take four forms of investing:

  • Investing to be able to put down a deposit on a house in say three years.
  • Investing to buy a house, but with no specific time frame.
  • Investing to build a portfolio to fund retirement.
  • Investing to fund your retirement income.

Investing to be able to put down a deposit in a house in say three years

Because of the volatility of equities, putting all your money in equities would be risky, and where you do look at equity, opt for low risk, high dividend paying companies. But, beware. Under such circumstances, a cash ISA may be worth considering.

Investing to buy a house, but with no specific time frame

If on the other hand, you can take an incredibly pragmatic view and buy a property when you feel your portfolio has reached a sufficient level, then this may require a different approach. If you were to build up an ISA portfolio, but investing a set amount of money every month, then if you get your timing right, and the rises and falls in the stock market favour you, then such an approach may pay-off quite quickly. If you are unlucky, and the rises and falls in stock markets work against you, such an approach may take longer. Just remember; if you are lucky, investing with a short time horizon can pay-off handsomely. If you are unlucky, in the longer term, investing will still probably be a lot more profitable than cash.

Investing to build a portfolio to fund retirement

This calls for a similar approach to the previous scenario above, but the time frame will probably be longer. Remember, equity investing tends to pay-off in the longer term. The longer the time frame, the more diversification, the less risky.

Investing to fund your retirement income

This requires a quite different approach. In this case, you need your ISA portfolio to provide income. A portfolio consisting largely of established firms operating in mature industries and which are good dividend payers might be the best approach. But some cash, to tide you over during times of stock market falls, might be worth considering.


These views are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees

Michael Baxter portrait photo
Michael Baxter

Economics Commentator

Michael is an economics, investment and technology writer, known for his entertaining style. He has previously been a full-time investor, founder of a technology company which was floated on the NASDAQ, and a director of a PR company specialising in IT.

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