The great popularity of Cash ISAs is somewhat surprising. After all, they offer an interest rate that is below the rate of inflation. This means that in the long run any amounts invested in them are losing their spending power.
Furthermore, the tax benefits of a Cash ISA have declined in recent years when compared to bog-standard savings accounts.
As such, an investor may be better off holding a relatively modest amount of cash in a savings account and investing the remainder of their wealth in FTSE 100 stocks instead. This could lead to higher returns, as well as a more efficient use of capital.
Cash appeal
Of course, having some cash at all times is a good idea. It can provide peace of mind, as well as the capacity to pay for exceptional and unexpected items. For example, housing repairs and a loss of employment are events that can occur without prior notice, so having enough cash to cover them in the short run is a worthwhile move.
However, having a significant proportion of your wealth in cash can lead to a disappointing financial outcome in the long run. Put simply, cash is unlikely to deliver a positive real-terms return. As I said, inflation is currently being ahead of the best interest rates that are available on a Cash ISA.
Although there is the potential for interest rates to move higher, historically a tighter monetary policy has often been prompted by a rising inflation rate. This means that on a real-terms basis cash could lead to a reduction in your wealth in the long run due to its returns consistently being behind the rate of inflation.
Stock market appeal
By contrast, the stock market could offer positive real-terms returns in the long run. It has a track record of delivering total returns that are in the high single-digits on an annualised basis, which is likely to be ahead of the inflation rate.
Furthermore, the FTSE 100 appears to offer a wide range of companies that have margins of safety at the present time. A number of stocks – especially those with exposure to the UK economy – have price-to-earnings (P/E) ratios that are below their historic averages. This suggests that they may be able to offer long-term capital growth potential that could produce above-average returns for investors.
Tax changes
While Cash ISAs previously offered significant tax advantages versus a bog-standard savings account, changes in recent years mean that the first £1,000 in interest received outside of a Cash ISA is tax-free.
As such, it may be worth holding cash in a bog-standard savings account, rather than in a Cash ISA. This could mean that you are able to capitalise on the tax efficiencies offered by a Stocks and Shares ISA, which could further enhance your returns in the long run.
