At the time of writing, the best Cash ISA on the market offers an interest rate of just 1.31%. When compared to the 6% dividend yield on the FTSE 100, this level of income looks hugely disappointing.
This higher level of income is just one of the reasons why FTSE 100 stocks could be a better buy than a Cash ISA.
Cash ISA risks
Cash ISAs are a great tool you can use to save for the future. However, with interest rates where they are today, it does not make much sense to have a lot of money stashed in one of these tax-efficient wrappers.
Over the past decade, the inflation rate in the UK as averaged around 2%. If the rate of inflation returns to this average, savers receiving 1.31% on their money would be left behind.
An inflation rate of 2% and an interest rate of 1.31% implies a real (inflation-adjusted) rate of interest of -0.69%. A Cash ISA with a negative real rate of interest does not look like a good investment to me.
As a result, while FTSE 100 stocks might look like the riskier proposition right now, from a long-term perspective, they could be the far better option. Indeed, for the three decades to the beginning of March 2020, the FTSE 100 had produced an average annual return of around 9%.
This annual return isn’t guaranteed, but stocks tend to rise in line with economic growth over the long run.
They are also an excellent hedge against inflation. Companies can increase prices in line with rising costs, which pushes up earnings and, potentially, dividend income.
Meanwhile, cash investors have to hope interest rates go up. As we’ve seen over the past decade, that is unlikely in the near term.
International diversification
Another benefit of owning the Footsie 100 over a Cash ISA is the international diversification the index provides.
Around 70% of the index’s profits come from outside the UK. This means that even if the UK economy stutters, as long as global growth continues, the blue-chip index should continue to provide a positive return for investors.
That means a partial hedge against any negative economic fallout from Brexit.
Look to the long term
So overall, while stocks might look like a riskier proposition than a Cash ISA at the moment, over the next three to five years, the FTSE 100 could be the better investment.
Company earnings should return to grow the next year when the coronavirus outbreak is under control. Over the following few years, earning should grow steadily.
On the other hand, there’s no telling when interest rates will rise again. Savers could be looking at another 10 years of near-zero interest rates. If inflation returns to its long term average, it could result in a reduction in the purchasing power of your hard-earned money.
Not only does the FTSE 100 offer some protection against the scourge of inflation, but it also has international diversification, and there’s the potential for a 6% dividend yield when the economy returns to normal again.
