I think 2020 is providing a great chance for those hoping to become ISA millionaires. Now, you might read talk of millionaire ambitions from time to time, and you might think it’s a bit far-fetched. But estimates suggest there are already 1,000 ISA millionaires in the UK. That’s over a period of only 20 years, starting with PEPs, which were introduced in 1999 and later converted to ISAs.
That’s proof that you actually can do it, by taking advantage of two key things. The tax saving is one, but it’s not the most important. No, what really does the trick is the magic of compounding. What that means is that you reinvest all the profits from your investments every year, and let it all build up… and up and up.
With a Stocks and Shares ISA, that means letting your dividends accumulate and then buying more shares. Talking of compounding, this is a good point to mention a Cash ISA. And, specifically, how bad they are. To make compounding work, you do need to achieve a certain minimum return each year. It’s critically important that you first beat inflation, and then any extra returns above that will translate to actual profit in real terms.
Which is the best ISA?
With a Cash ISA, you’d do well to get above 1% per year. The UK inflation rate has dropped to around zero right now, so that is actually positive, if only briefly. But we’re obviously hit by the Covid-19 crisis right now. And over the slightly longer term, the UK inflation rate has been running at around 2%.
There’s only one way you can end up with a million pounds, adjusted for inflation, from a Cash ISA that doesn’t match inflation. That’s to invest the equivalent of more than a million and see it dwindle, which is no way to investment success.
The UK stock market, by contrast, has provided an average total return (that’s share price growth plus dividends) of 4.9% above inflation for around a century. And I see no reason to think that’s going to change over the next hundred years.
If you could invest the full £20,000 per year in a Stocks and Shares ISA, and you get that average annual return of 4.9% above inflation, you’d reach your inflation-adjusted million in 26 years. Over a lifetime, that’s really not very long – but £20,000 per year is a big investment.
It’s a lot easier if you’re a younger investor with, say, 40 years at your disposal. To reach the target million in 40 years at the same rate of return, you’d need to invest around £8,280 per year. That’s £690 per month, and a lot more realistic for many more people.
But why do I suggest now could be a once-in-a-lifetime opportunity? The length of time you invest in an ISA is key, and the longer the better. But the early days are more important, and better returns in the first few years can make a much bigger difference than towards the end.
So in 2020, starting when the stock market is down could give you an extra boost. Especially if you make the effort to invest as much as you can in the first few years.
Views expressed 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.