It must be the dream of many people to become an ISA millionaire. And it’s not an unobtainable goal because there are an estimated 1,000 people in the UK with an ISA worth £1m or more. But if you are going to do it, you’ll need a plan. I suggest starting with the following three steps.
Because of the way the process of compounding works, it pays to aim to maximise annualised returns. Compounding is key to building wealth and becoming an ISA millionaire, but the size of your eventual pot of money depends on two variables.
The first is the length of time that you compound your investments. Compounding works exponentially, which means your absolute returns in pound notes accelerate over the years for any given annualised rate of return. So you’ll see huge amounts of money building up after compounding for 30 years compared to after just two years.
The second variable is the return you achieve each year. If you average an annualised return of, say, 8%, it will make a huge difference to your eventual pot compared to achieving 5% each year. Little increases in the annualised return compound out to big differences in your eventual pot of money.
So I’d avoid a cash ISA because the interest rates paid on cash accounts are poor. Instead, I’d go for a Stocks and Shares ISA. Over the long haul, studies have shown the annualised rate of return from the general stock market has been in high single-digit percentages. And it’s possible to do even better than that with some careful stock-picking.
The maximum ISA allowance is currently £20,000. If you could invest the full amount each year and earn an annualised return of 5%, you’ll end up with around a million after 25 years. However, many people will probably find it difficult to invest as much as that.
But as step two, I’d invest as much possible regularly into my stocks and shares ISA. Indeed, setting up a monthly transfer of money into your ISA from your current account can be a good idea. Then I’d aim to increase the rate of compounding by targeting higher annualised returns. To do that, I’d consider putting my money in investment trusts, alongside some carefully chosen shares that are backed by good-quality businesses.
If you can’t invest the full ISA allowance, you can increase the period of compounding. So starting as early as possible is a good idea.
The final step is to keep investing no matter what the stock market does. Right now, many shares have been weakened because of the effects of the coronavirus crisis. But it’s a good time to invest because in many cases we can get more for our money when we invest in shares and share-backed instruments such as funds.
Over a long period measured in decades, the investments we make in troubled times can end up being some of our best and us to become an ISA millionaire. If we choose our targets carefully.
Kevin Godbold has no position in any share 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.