The 'rainbow of risk' for ISA investors
We look at the safest and riskiest investments you can make through an ISA.
The clock is ticking if you want to use your £15,000 ISA allowance before the end of the tax year on 6th April.
We have put together a 10-step 'rainbow of risk' to rank ISA investments in order of their risk of loss, to help you make the best decision when choosing how to use your money.
1. Cash
Keeping your spare funds inside a Cash ISA is the safest thing to do with your money. Not only is your capital not at risk, it's also backed by the Financial Services Compensation Scheme (FSCS). This covers 100% of the first £85,000 of cash deposits per person, per authorised institution.
The big problem with Cash ISAs is their poor long-term returns, as almost all Cash ISAs pay interest rates below 2% a year. Your money will be safe, but it will grow very slowly.
Compare Cash ISA rates with lovemoney.com
2. Government and corporate bonds
Bonds are IOUs issued by governments, companies and other organisations. These debts are known as fixed-income investments, because they pay a fixed rate of interest throughout their lives. When your bond matures, you get back the sum you originally invested.
Bond coupons (their regular payments) range from below 1% for AAA-rated bonds right up to double-digit payouts from high-risk bonds such as Greek government debt. The risk spectrum for bonds goes from ultra-safe all the way up to high-yielding or 'junk' corporate bonds. A safer way to invest in bonds inside your ISA is via a bond fund run by an acclaimed manager.
3. Peer-to-peer lending
Peer-to-peer lending uses an internet platform to connect savers looking for higher returns with individuals and companies looking for non-bank loans. This is a booming business, with lenders arranging nearly £1.3 billion of personal and business loans last year, almost triple the £480 million lent in 2013.
Peer-to-peer loans can't be placed inside your ISA just yet, but the Government is committed to including them this year. And when they do, peer-to-peer loans are a relatively safe option, depending on which firm you choose to lend through. Returns from the big peer-to-peer lenders like Zopa, RateSetter and LendingWorks all exceed 5% at the moment, and they all have provision funds in place to cover any bad debt.
Compare peer-to-peer lending rates in our saving centre
4. Index trackers
An index tracker is one of the simplest collective investments around. Quite simply, it is a fund (or Exchange-Traded Fund) that tracks a particular index, mimicking the performance of that market. The cheapest tracker funds (those following the FTSE 100 or FTSE All-Share) charge less than 0.1% a year in management fees.
The great thing about owning a tracker fund is that while you don't beat the wider market, you also don't grossly underperform it. In fact, research has repeatedly shown that index trackers actually outperform managed funds.
Invest in a tracker through a Stocks & Shares ISA
5. Managed funds
With a managed fund, you hand over your cash to a professional fund manager, who places investors' money into shares or bonds, or property. The big problem with managed funds is their various layers of fees, which easily can guzzle, say, 1% to 2% of your yearly returns.
As nine out of 10 fund managers fail to beat their benchmarks over 20 years, sorting fund managers into tomorrow's stars and dogs is a thorny task. Be wary of all brokers and financial firms claiming success with identifying the star fund managers of the future, as picking active managers is almost as hard as picking shares themselves.
Invest in managed funds through a Stocks & Shares ISA
6. Big firm shares
With collective investment such as index trackers and managed funds, your money is diversified: spread across a wide range of shares. In contrast, buying individual shares concentrates your portfolio and makes it riskier.
The largest, most liquid and least volatile shares listed on the London Stock Exchange are those issued by members of the FTSE 100 index of elite British businesses.
These shares are very widely held and easy to trade in volume. Also, most pay decent dividends, which are regular cash payouts to shareholders.
7. FTSE 250 shares
Just as the FTSE 100 includes the UK's 100 biggest London-listed companies, FTSE 250 members comprise the next 250 largest listed firms.
The FTSE 250 is much more UK-focused than the multi-national FTSE 100, making it a better gauge of UK growth. However, it's a smaller, less liquid and more volatile hunting ground for shares.
Despite these extra risks, mid-cap shares have - on average - thrashed blue chips over one, three, five and 10 years. Then again, FTSE 250 firms can be really risky, with a fair few blowing up or going bust during the global financial crisis.
Buy shares through a Stocks & Shares ISA
8. Overseas shares
Holding a UK-centric portfolio risks missing out on foreign growth, especially in fast-growing developing nations. But overseas investments are fraught with perils, like currency risk wiping out your returns.
Overseas shares are harder to trade and to risk-rate too, thanks to widely different standards of accounting, property rights and the repeated asset seizures.
9. AIM shares
The Alternative Investment Market (AIM) is the London Stock Exchange's junior market for small and growing companies. Since the launch of AIM in 1995, more than 3,000 companies have listed on this growth market. AIM is less tightly regulated than the LSE, so blow-ups and accounting scandals happen fairly frequently.
Although there are valuable Inheritance Tax breaks to be had from owning AIM-quoted shares, 100% capital losses are fairly common. Investing in AIM shares via a respected and well-managed fund is probably the safest option.
10. Crowdfunded shares
At present, investors cannot hold crowd-funded shares and bonds inside ISAs, but this is likely to be an option by next year.
Driven by platforms such as Seedrs, Crowdcube and Syndicate Room, crowdfunding of early-stage businesses is experiencing explosive growth, with £84 million raised last year in equity crowd-funding. But crowdfunded shares are incredibly risky, because you are buying shares in start-ups, early-stage firms and the smallest of businesses, and the vast majority go bust within the first few years.
If you want to invest in high-risk ventures, then forget your ISA. Instead, explore Venture Capital Trusts (VCTs), as these offer generous tax relief to compensate for the added risks.
More on ISAs and investing:
Stocks & Shares ISA deadlines for 2014/15
Seven deadly ISA sins to avoid
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