SAVERS are having to take on more risk as cash returns are wiped out by inflation – a state of affairs which seems certain to continue for at least two more years.
Interest rates have now been sitting at 0.5 per cent since March 2009, a boon for borrowers but a burden for savers. Anyone with money in a savings account will have struggled for some time to get a real (post-inflation) return on their money. With the consumer prices index at 2.8 per cent, a taxed savings account for a basic-rate taxpayer would need to exceed 3.5 per cent gross a year to provide a real return.
For a higher-rate taxpayer the interest rate would need to be greater than 4.67 per cent, rising to 5.6 per cent a year for an additional rate taxpayer.
The average cash Isa pays just 1.67 per cent, down from 2.44 per cent last August. That was when the Funding for Lending Scheme launched, giving providers access to cheaper finance and reducing their need to attract savings deposits.
And there’s little chance of things improving any time soon, with Bank of England governor Mark Carney recently indicating that the base rate will remain unchanged until the unemployment rate falls to 7 per cent or lower – likely to be 2016 at the earliest.
So how can you convert these paltry cash returns into better long-term growth?
If you have funds held in cash Isas and don’t need the capital in the short term, transferring these to a stocks and shares Isa will give a higher probability of success if you buy and hold for a long period of time.
Let’s look at the evidence. If you’d invested entirely in fixed interest securities (such as corporate bonds and gilts) between 1988 and the end of last year you’d have achieved a compound annual return of 5.7 per cent, according to data from Dimensional Fund Advisors. This means £100,000 would have been turned into £398,000 over the 25 years.
A portfolio with 100 per cent exposure to global equities would have achieved an annual return of 9.2 per cent. A £100,000 investment in 1988 would have grown to £908,000 – a £510,000 premium for participating in shares.
The added advantage of investing in the stock market within an Isa wrapper (the allowance for 2013-14 is £11,520) is that investment growth is not subject to capital gains tax, and any interest or dividends are free of income tax. This is great news for higher-rate taxpayers, as funds that produce dividends can be re-invested in the portfolio free of tax.
Of course, I’m not suggesting that all investors should put all of their money into high-risk investments. However, certain stock market investments – such as blue-chip shares with high yields – are deemed less risky than others.
In the hunt for income, investors are expected to continue to gradually move from lower-risk assets, such as cash and bonds, into riskier assets such as equities, in what has been dubbed the “great rotation”.
As confidence increases that growth is returning, more money should flow to equities, driving up share prices. Areas such as the UK and US will initially do well, but as investor confidence increases, regions such as China, India and other emerging markets could really benefit if risk appetite returns.
However, as it’s impossible to predict which of these sectors will produce the highest returns, make sure you are diversified across all sectors and rebalance your portfolio annually (selling markets when they are high and buying into others when they are low).
Carefully consider your tolerance for volatility and capacity for loss before establishing your risk profile, preferably with the help of a financial planner. When designing a portfolio in line with your risk profile, your investment should be spread across several asset classes and geographical sectors.
This process is known as “asset allocation” and studies have found that this is more important than the actual process of choosing stocks, bonds and funds.
Studies have also found that very few active fund managers reliably beat stock market returns over long periods of time, whereas less expensive passive funds with a tilt towards smaller companies and value companies tend to enhance returns over time.
Of course, the most cautious of investors should remain in cash, sheltering £5,760 during 2013-14 from the taxman. However, make sure you regularly review your accounts to ensure they are earning the most competitive rates of interest.
• Kevin Mackenzie is a financial planner at Acumen Financial Planning