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Why a stocks and shares ISA beats a cash ISA every time

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The new ISA year has started and we have an allowance of £20,000 to use up. That’s the amount we can invest over the year without paying any tax on interest or capital gains (or higher rates of tax on dividends). And to my mind that’s a terrific incentive to go for the one thing that beats all other forms of investment hands down over the long-term — shares in top quality British companies.

But it saddens me that 75% of ISAs taken out every year are cash ISAs. Sure, if you have some cash savings it’s nice not to pay tax on the interest, but how much are we actually talking about here?

Hardly worth it

A quick search for best cash ISA rate shows we’re generally looking at less than 2% interest per year. Even assuming you can stash away the whole £20,000 and that you’re a higher-rate tax payer, you’ll only be saving around £150 per year maximum.

Another thing that confuses many people is the creative marketing used to sell ISAs. A friend recently asked me if I had any idea why the interest rate had suddenly dropped on his ISA, and it seems he’d been sold an ISA with a fixed-term rate which had just expired — and it had fallen to only around 1.5%.

Now, you can transfer to another provider if that happens, but how many people will bother with all that palaver? A cash ISA is a great thing — for the people who sell them, not for ordinary investors.

Shares come out tops

If, instead, you take out a stock and shares ISA (which is a silly name, as stocks and shares are the same thing), all you’d need to do to beat the income from cash is buy a FTSE 100 index tracker. Over the long term, the UK’s top index has been providing dividends of around 3% per year, though over the past 12 months it’s done a little better. 

If you’re after bigger dividends, you can buy some high-yielding shares directly. Utility companies are typically big payers — National Grid at around 5% per year, with SSE on about 6%. BP and Royal Dutch Shell also offer big dividends, as do some of our top insurers and housebuilders.

That’s just the dividends, and I haven’t even looked at share price appreciation yet, so what should you expect over the long term? Since the inception of the FTSE 100 index in 1984, it has increased in value by nearly 600% — so every £1,000 invested back then is now worth nearly £7,000. 

Of course, you’ll have some years when the value of your shares falls, which is why buying them should always be seen as a long-term investment. How do the ups and downs pan out?

How long?

Barclays publishes its annual Equity-Gilt study, which compares various kinds of investment every year since 1899. And it has discovered that over rolling 10-year periods, shares have beaten cash 91% of the time. Over 18-year periods, that figure rises to 99%, and over 23-year periods shares have never once been beaten by cash — and in most periods, shares came out way ahead.

And it calculates that £100 invested in the UK stock market in 1945, with all dividends reinvested, would be worth close to an inflation-adjusted £180,000 now.

ISAs are wonderful, but I reckon you’re wasting a great opportunity if you go for cash rather than shares.

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Alan Oscroft has no position in any shares mentioned. The Motley Fool UK has recommended Barclays, BP, and Royal Dutch Shell. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.