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The Cash ISA is a huge risk to your wealth. Here’s what I’d do instead

The Cash ISA remains alarmingly popular in the UK. I say ‘alarmingly’ for the simple reason that these accounts still offer a paltry return (1.44% at best) that’s below inflation (2%). Assuming interest rates don’t jump any time soon, money stored in this kind of account will be losing value.

The eroding impact of inflation is why it makes little sense to hold cash beyond having an emergency fund for when the going gets tough. A rough rule of thumb is anywhere between three-to-six months’ worth of living costs — enough to get you through a short period of unemployment. Anything beyond this and you’re drastically reducing your chances of building any kind of wealth in your lifetime.

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To achieve the latter, you’re going to need a generous proportion of whatever money you do have in assets that have been shown to outperform. And that means equities.

But isn’t investing risky?

One of the biggest misunderstandings of those who keep all their cash stored in a Cash ISA is that investing — as opposed to saving — is always riskier. News of household names going bust or investors being prevented from withdrawing their money from funds only serve to perpetuate this belief.

It’s true that cash offers far more security. After all, the first £85,000 of anyone’s savings are guaranteed by the Financial Services Compensation Scheme in the event of their bank going bust.

But while stocks and shares carry more risk in the near term, it’s also vital to recognise that the reverse is true as the years pass.

Research has consistently shown that equities outperform all other asset classes if held long enough. The most recent Barclays Equity Gilt Study, for example, revealed that UK stocks had returned 5.8% a year over the last decade compared to -2.5% for cash. It also showed that an investment held for 10 years at any point between 1899 and 2018 would have outperformed cash 91% of the time.

While there can be no guarantees that future returns will be similar to those of the past, that’s the sort of probability I’d be looking for when it comes to determining what to do with my money. 

Don’t forget the dividends

Of course, looking one year ahead is difficult enough for most of us, let alone talk of leaving money to grow for decades. Add to this the fact that there’s always the potential for markets to be volatile over a short period of time (the FTSE 100 fell around 40% in value between 2007 and 2009) and it’s no wonder many people in the UK still shun the former. 

That said, there is a silver lining to this cloud of unpredictability in the form of dividends. Receiving bi-annual or quarterly payouts from companies can be soothing, especially if the value of their shares have temporarily fallen as a result of a market crash. And if you don’t feel comfortable buying individual stocks, a low-cost exchange-traded fund tracking the FTSE 100 is a good alternative. It yields 4.4% — three times the interest of the top instant access Cash ISA.

But the power of dividends goes beyond the relief they provide in difficult times. £100 invested at the end of the Second World War would now be worth £244 after inflation. With all income reinvested, however, that same £100 would be worth £5,573 — another reminder to ignore the power of compounding at your peril.

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Paul Summers has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.