There comes a time in any person’s life when they have accumulated enough savings to start thinking about planning for retirement. You’ve built up a good cash cushion for emergencies and day-to-day spending – now it’s time to let your hard-earned money do the work for you. You may consider simply leaving your savings in a Cash ISA, but I believe that would be a mistake. Here’s why.
The downsides of cash
One of the main reasons why a Cash ISA is unlikely to get you to an early retirement is the extremely low interest rates that savers are currently being offered on these accounts. The best that you are likely to get is 1.9%. To put this into perspective, £10,000 invested for 40 years at this rate would compound to £21,231 – not exactly a world-beating return.
The other reason why a Cash ISA is not an attractive option is inflation. Prices have risen on average by 3.8% since 1980, meaning that something that cost £10,000 in 1980 would cost approximately £43,204 today. This means that if you had £10,000 in cash in 1980 and chose to do nothing with it, that sum of money would be worth just £2,310!
The advantage of a Stocks and Shares ISA
Now, compare a Cash ISA to a Stocks and Shares ISA. Over the last 25 years (a fairly big sample size), the average annual return of the FTSE 100 (assuming reinvestment of all dividends) was 6.4%. So just by tracking the index, and not doing any stock picking, you could achieve a rate of return that far outstrips anything that cash could produce. £10,000 invested at that rate for 40 years will grow to £119,582!
What’s more, inflation does not erode the value of a stock portfolio like it does cash. Your share of ownership of a company will be the same regardless of the value of the currency it is denominated in.
What are the risks?
You may think that there’s a catch – that investing in a Stocks and Shares ISA is riskier than holding cash, that what can go up can also go down. There are a few responses to this. First, I hope that I have demonstrated fairly clearly that there are hidden risks to holding cash – inflation and the opportunity cost of missing out on the superior returns of the stock market.
Second, stock market investing is only risky when you invest at high valuations. By being smart with your money and choosing stocks that are well-priced, you can minimise this risk significantly. So yes, stocks have a lot more volatility than cash, but would you rather invest in something that will compound at an average 6.4% rate when invested correctly, or something that you know for a fact will lose its value? I think the answer is pretty obvious.
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Neither Stepan nor The Motley Fool UK have a 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.