With a Cash ISA, the rules are simple.
You can add up to £20,000 a year, then collect interest on the balance.
Although this is easy, you’re restricted by what you can do with your money. And today’s interest rates are miniscule.
In short, the biggest cost of using Cash ISAs is the opportunity cost.
Your money could potentially work much harder elsewhere.
A Stocks & Shares ISA gives you more opportunities
Same as a Cash ISA, you pay no tax on what you make.
You can also manage how you use your ISA, depending on your tolerance for risk.
What are the 3 key ways you can use a Stocks and Shares ISA?
- You can buy stocks and bonds on your own. This is most efficient if you have some investing know-how. Or if you get help from investment newsletters like Motley Fool Share Advisor. You only pay your usual brokerage fees to place trades. You also stand to make greater gains.
- You can invest in active funds. Many brokerages offer their own managed funds which you can hold in an ISA. Fidelity, for example, lets you choose how you want to invest (for income or growth). It also asks questions about your risk tolerance. You’re then matched to a fund that suits your needs.
‘Active funds’ are actively managed by real people. When you add savings, that money is pooled into the fund and allocated on your behalf.
- You can invest in passive funds. A passive fund doesn’t rely on any human decision-making. It simply tracks a benchmark index. For instance, you can buy a FTSE-100 passive fund which (no surprise) follows the FTSE-100. As companies are added or removed from the list, the fund automatically follows.
[top_pitch]
Passive funds are most popular
They’re cheap and efficient.
Since you don’t have active managers the fees are much lower (typically below 0.50%).
You lose the hassle buying shares yourself.
Everything is done for you in one easy fund.
Passive funds have also outperformed active funds – by a lot.
According to MarketWatch, from 2009-2019, only 23% of active funds beat their average passive rival.
You pay lower fees and get a higher return.
What’s not to like?
Well, you should be careful.
[middle_pitch]
Passive funds have hidden risks that few people consider
These risks are arguably greater now than ever before.
First, passive funds have benefited from the enormous combined wealth of baby boomers.
Now this generation is retiring, they’re starting to draw from their savings. Since baby boomers are such a large, wealthy generation, passive funds will not necessarily match their previous performance.
Many passive funds are also market-weighted.
This means each holding is sized relative to the underlying company’s value.
Suppose you have a fund tracking the S&P500 (an index of 500 large U.S. companies). You won’t necessarily hold those companies in equal amounts. Since a company like Apple is extremely valuable, it might take a larger portion of the fund.
If Apple grows faster than other companies, it will push out your other holdings.
This exposes the biggest risk of passive investing.
As more money flows into the fund, more money chases those companies at the top.
Amazingly, the S&P500’s top 6 companies have a larger combined value than the bottom 494!
If they make up the bulk of your fund, you’re effectively “buying high.”
And you might not be well diversified at all.
How should you diversify in a Stocks & Shares ISA?
One possible solution is to use all three of the key methods mentioned.
You can use active and passive funds to help limit your risks across the stock market.
And you can do your own research to pick individual shares which you think are undervalued.
If you do this, set yourself some ground rules. For instance: “no more than 20% of your money in any fund, and no more than 5% in any stock.”
This stops you making haphazard emotional decisions.
