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What Is A Stocks & Shares ISA & How Does It Work?

Stocks and Shares Explained - Lesson Resource | Business | tutor2u

If cash savings aren’t delivering the returns you want, it can be worth considering a stocks & shares ISA.

Similarly, if you’d like to start investing in the stock market, this kind of ISA is a good first step.

This introduction shows you how they work and gives an overview of some of the options, from index tracker ISAs to riskier ETFs (exchange-traded funds) focusing on emerging markets.

Whether you’re a beginner or a slightly more experienced investor, here’s what you need to know about stocks & shares ISAs to get started.

What is a stocks & shares ISA?

An ISA (individual savings account) is a tax-efficient savings product. Interest or growth from an ISA isn’t subject to tax in the way that ordinary savings or investments would be. ISAs may therefore deliver more reliable long-term growth than many of the alternatives.

You can save up to £20,000 per year into ISAs – this is known as your ISA allowance.

A stocks & shares ISA is one that holds investments instead of cash. Despite the name, it can hold a wider range of investments than just equities (stocks & shares) alone, and may include bonds and investments funds and/or investment trusts too.

Typically, you will choose an ISA provider, who then offers you a range of products to choose from. These may be ready made (‘off the peg’) or bespoke.

How do stocks & shares ISAs work?

When setting up your stocks & shares ISA, you’ll get to choose what investments to place inside it. This is a critical step that determines both the risk level and potential growth of the ISA, so it’s worth taking financial advice at this point. At the very least, you should read carefully the documents from the ISA provider, to ensure you understand the various funds and assets in which your money may be invested.

When you invest in a fund via your ISA, you will purchase units (essentially your share of the fund), which will go up and down in price depending on the price of the underlying assets each day. So if a fund unit costs £1, you could purchase a thousand units for £1,000. If the price of a unit rises to £1.20 a few months later, your investment will now be worth £1,200. If it drops to 80 pence per unit, then you’ll have £800, and so on.

Shares held in a stocks & shares ISA can also benefit from dividends if the company chooses to pay them. This can further boost the ISA’s tax-free growth.

What are the benefits of a stocks and shares ISA?

The obvious benefit of a stocks & shares ISA is that it allows you to invest in a range of investments without paying capital gains tax (CGT) on the growth (which you might otherwise have to do, if you exceed your CGT allowance).

This can be particularly useful if you’ve made other capital gains elsewhere in that year, such as by selling a second property. Selling a large asset like this can wipe out your CGT allowance, so holding other investments in an ISA can protect that growth from tax.

A stocks & shares ISA is also a great introduction to investing in general. Remember, your ISA is simply a vehicle for investment, rather than a type of investment itself, so you’ll have plenty of choice about the investments you choose.

In this way, you can get a feel for how different types of investments behave over time, and how to judge the right level of risk for you. This can be very useful if you plan to expand your investments beyond ISAs in the future – but even if you do, you should always use up your ISA allowance first, for the valuable tax benefits.

Another clear benefit of a stocks & shares ISA over a cash ISA is that the potential for growth is much higher.

A cash ISA is limited by the interest rate being offered, and if the Bank of England base rate is low then your account may pay hardly any interest. In this case, your interest rate may not beat inflation, so the real value of your savings may actually diminish over time.

Furthermore, the personal savings allowance means that the first £1,000 of interest on cash savings is tax free anyway. This means that only someone with a very large amount of cash savings needs to worry about tax on their interest, for as long as rates remain low.

By contrast, a stocks & shares ISA does offer the potential for actively growing your money over time to beat inflation, while saving you tax at the same time. Of course, this comes with an increased level of risk, which we’ll cover next.

What are the disadvantages of a stocks and shares ISA?

Stocks & shares are considered high risk or ‘volatile’ assets. Volatile means they are prone to sudden changes in value, either rises or falls. This means that any investment in the stock market can go down as well as up, and a market crash can result in heavy losses. For this reason, equities are not recommended as a short-term investment except for very experienced investors who know how to ‘time the market’ – and even these experts may frequently get it wrong.

This volatility means that it may not always be practical to access your money when you need it. Although you can usually withdraw from a stocks & shares ISA within a few days (you have to wait for the investments to be sold and converted into cash first), it may not be a good time to sell.

For example, if you have spent five years watching your investment grow, only for a market crash to wipe out much of that growth, you will not want to sell at this point and waste five years of investing. It will be sensible to wait for the market to recover to close to its previous levels. This may place your ISA temporarily ‘off limits’ for you, except in a real emergency.

Ideally, you will want to plan any withdrawals carefully so that you sell at a time when your investments are doing well. This can be hard to predict, so it’s best to err on the side of caution.

As for other disadvantages, the upper ISA limit of £20,000 per year restricts the amount you can put away. If you have a lot of money to invest, you’ll have to look at less tax-efficient alternatives in the short term and drip-feed your money into ISAs over the years.

However, while interest rates on cash are low, you may decide to use all your ISA allowance for stocks & shares and put your cash into regular savings accounts instead.

Should I invest in a stocks and shares ISA?

Stocks & shares ISAs can be a great vehicle for saving for mid-term or longer-term goals. If you have money that you feel able to put away for several years without touching it, then a stocks & shares ISA will in most cases deliver better value than cash savings.

Stocks & shares ISAs are particularly popular for Junior ISAs, where saving can begin when the child is a baby and continue until they reach 18. Eighteen years is a very good length of time for stock market investment, and historical growth over similar periods period has almost invariably beaten inflation and cash savings.

Though still vulnerable to stock market crashes, a Junior ISA containing stocks and shares is generally a better choice than a cash one.

Stocks & shares ISAs can also be good for saving up for long-term goals, such as buying a home or retiring. Both of these goals can be achieved via a Lifetime ISA (which may be either cash or stocks & shares), but these ISAs comes with certain restrictions, so some savers may prefer a standard stocks & shares ISA.

It is worth bearing in mind that a cash ISA is not risk-free. With cash, you risk missing out on growth, or your money losing value due to inflation. This is something to consider when weighing up the risks and rewards of the different types of ISA.

How to buy a stocks and shares ISA 

To open a stocks and shares ISA, you’ll need to decide how much you want to invest. Remember that you can invest up to £20,000 of tax-free money into an ISA, so decide what proportion of that amount you’d be happy investing (or can invest).  

You then need to select a platform or provider to open your ISA. You can choose for yourself what stocks and shares you want to invest in, delegate someone else to take care of the investing, or potentially pick from a pre-set ISA with a set number of investments. 

If you choose to pick your investments from scratch, you should pay close attention to additional fees that you will need to pay when carrying out your investments. Platforms and providers will take fees throughout the transaction, meaning you could end up with less than you had originally calculated.  

Robo stocks and shares ISAs

Some ISAs may not even need any manual interference at all. So-called ‘robo-ISAs’ rely on complex algorithms and artificial intelligence to make investment decisions for you. Robo-ISAs are not cheap, but based on the criteria and risk profile that you have agreed to, these ISAs will generally speaking tick over in the background, meaning you only need to pay attention to your returns. Robo-ISAs follow predictable investment strategies, meaning they are no more risk-friendly than a relatively conservative investor.  

Who provides stocks and shares ISAs?

Mainstream banks and large investment companies offer stocks & shares ISAs. If you want to keep the fees down, the most cost-efficient option is to use an online platform.

If you’re a confident investor, you can opt for a DIY trading platform, which will offer you little to no direction or guidance and usually have lower fees. Popular options include Cavendish Online, iWeb and II (Interactive Investor).

There are also platforms that can offer more advice, and fully-managed investment options that decide where to invest on your behalf. However, you will generally have to pay higher fund manager charges if you go for a fully-managed option, which can eat into your returns. Wealthify, Hargreaves Lansdown and OpenMoney are some of the largest platforms.

How to pick the best stocks & shares ISA provider

You’ll need to do your own research before choosing a provider, as each option has different pros and cons. The cheapest option won’t always be the right one for you. Make sure you’re considering factors such as:

  • which funds you can access
  • the number of funds
  • the annual platform charge
  • transfer out fees
  • account closure fee
  • fund dealing charge

It’s also sensible to think about how easy your chosen platform is to use. If you’re going to be regularly trading, an easily accessible app will make it simpler for you to do so, while platforms that automatically reinvest dividends will suit passive investors looking for good returns.

A comparison website will make it easy to compare options if you know what you’re looking for. Similarly, an investment broker can help you decide which platform works best for you, but their advice will not necessarily be impartial.

There’s no one-size-fits-all stocks & shares ISA, so getting impartial advice from an independent financial advisor (IFA) can make it much easier to find the right option for you. What’s more, they can help you pick the right investments for your circumstances and manage your portfolio on your behalf. 

What should I invest in with my stocks & shares ISA?

You can invest in whatever you like, but the first thing you should consider is what you’d like to achieve through investing.

Is stability a priority, or are you happy to risk losses in exchange for the chance of higher returns? Are you investing for a specific purpose (such as retirement or to build a nest-egg for your children) or are you simply trying to make your money work harder than it would in savings?

Next, think about the impact you want your investments to have. Are you driven by ethics and want to support other companies/causes that share your ethos, or are other factors more important to you?

You’ll also need to consider how much work you’re willing to put in to managing your funds and how long you’re happy to tie them up for. Again, if you’re not sure, it’s best to get advice before investing – making ill-informed investments could be a costly decision.

What are the best performing stocks & shares ISA funds in 2022?

Here’s a quick snapshot of ten of the most popular ETFs of 2022 so far, which could be invested in via a stocks and shares ISA.

  • iShares Core FTSE 100 UCITS ETF
  • Vanguard FTSE 100 UCITS ET
  • Xtrackers FTSE 100 UCITS ETF
  • iShares plc FTSE 250
  • Vanguard Funds plc FTSE 250 UCITS ETF
  • iShares UK Dividend UCITS ETF
  • L&G FTSE 100 Super Short Strategy
  • SPDR FTSE UK All Share ETF
  • Lyxor Core Morningstar UK UCITS ETF
  • SPDR S7P UK Dividend Aristocrats

However – and this is incredibly important to remember – you should not take past performance as an indicator of how an investment is going to perform in the future.

The best ISA funds to invest in will change regularly, particularly in unpredictable economic conditions, so you’ll need to do your own research before investing in anything. Again, an IFA can help you with this decision, as they will have seen different funds perform over a full market cycle.

Also the meaning of ‘the best performing ISA’ will change depending on your goals. An investor that is looking to make lots of money relatively quickly and an investor that is seeking steady growth over a longer period will not be drawn to the same products.

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