How to inflation-proof your ISA

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ISA season is once again upon us, and with a new allowance of £20,000 that we can invest tax-free, the banks and building societies are starting to pitch their cash ISA offerings.

Looking round the comparison sites and at the interest rates on offer, I can see why folks might not exactly be biting their hands off — the best rates are only around 2.25%, with many offering little more than a pitiful 1%.

When UK inflation is currently running at around 3%, that won’t even retain the value of your savings, never mind grow them over time. 

In my view, the cash ISA is one of the worst investment products ever (among legal and honest ones, at least) and is a complete waste of time.

Yet in the 2016-17 tax year, UK investors shovelled £39bn into cash ISAs — although that was one of the lowest amounts in recent history, with the total down from a staggering £59bn the previous year.

Cash is a loser

I am, at least, pleased that UK savers appear to be realising that a cash ISA is very poor value. But it still pains me to read of so much money heading in such a poor direction, when there really is a far better opportunity out there — one that is likely to wipe the floor with cash investments and blow away inflation into the bargain.

I am, of course, talking of a Stocks and Shares ISA (where “stocks” and “shares” are really just two words for the same thing.) With one of those, you still get the same £20,000 allowance, but you get to invest it in shares instead — and that’s fairly widely interpreted to allow various funds, like investment trusts, which can make the selection process a good bit easier.

If you want to pick your own shares, there are plenty of approaches. My favoured ISA strategy is to buy shares in FTSE 100 companies paying good dividends, spreading the cash across different sectors for a bit of diversification.

But what kind of returns can you hope for if you invest in a shares ISA?

Well, the FTSE 100’s average dividend yield is standing at around 4.3% at the moment, and that trounces those horrendously low cash ISA interest rates — and that’s before you even consider any possible share price gains.

Beating the risk

You might think shares are a bit too risky for you and that you could lose money. That is true, you might. But the longer you invest for, the better are your chances of coming out well ahead.

The people at Barclays have been studying the records since 1899, and they’ve discovered that over rolling 10-year periods, shares have outperformed cash 91% of the time. Extend that to 18-year periods and the figure jumps to 99%. And if you stretch to 23-year periods, cash has never beaten shares even once — and that even includes the great crash of 1929 and other financial catastrophes.

In fact, the Barclays study calculates that £100 invested in UK shares in 1945, with dividends reinvested in new shares, would have grown to almost £180,000! And that’s after adjusting for inflation.

So yes, you can use an ISA to beat inflation, and possibly by a very handsome margin — by going for a shares ISA instead of a cash ISA, and holding for the long term.

ISA millionaire

There are even investors out there who have accumulated £1,000,000 and more in their ISA accounts, and I think that's definitely an achievable target. But it's unlikely to be a cash ISA that does it for you.

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Alan Oscroft has no position in any of the shares mentioned. The Motley Fool UK has recommended Barclays. 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.