Four reasons to consider using your ISA allowance

CLARE FRANCIS: Hello and welcome to another episode of Money Plan our regular personal finance podcast. I'm Clare Francis, Savings and Investments Director at Barclays. Fancy yourself being a millionaire, sounds attractive doesn't it and it's not beyond the realms of possibility. There are now thousands of investors across the country, who over the years have been diligently investing their annual ISA allowances and now have more than one million pounds within their ISA.

And today I'm joined by Rob Smith, Head of Behavioural Finance here at Barclays, and Alina Lobacheva who's a Senior Portfolio Manager and looks after the investments of some of our clients, to explore why investing can help boost your wealth and get your money working harder for you.

Before we start I just need to remind you that when it comes to investing stock markets can fall as well as rise, so there's always a chance you could lose some money. Also we're not offering personal advice, so if you're unsure about next steps please seek independent financial advice.

So ISA millionaires, what are your chances of becoming one? Well based on the current ISA allowance of £20,000, it would take about 25 years to become an ISA millionaire assuming an annual return of 5% on your investments.

Don't be put off if you can't afford to put £20,000 away each year, there are still strong reasons to consider investing. Similarly, if you're in the fortunate position of being able to invest more than £20,000 a year, it's still worth doing all you can to get your money working as hard as possible for you.

So Rob, Alina, thank you so much for joining me today. Rob can we start with you, it's great isn't it when you hear phrases like ISA millionaires, it makes your ears prick up and obviously you want to find out more, but in a way the headlines almost irrelevant because the important bit is the underlying point about the potential long-term growth you can get from investing, and the fact that hopefully you'll see your money increase in value by more than if you just left it all in cash savings.

Can you explain a bit about why this is the case?

ROB SMITH: Hi Claire, so as you say that ISA millionaire title is very is very catchy, you can see why it gets lots of people’s attention. I think when we think about how that potentially exists it's pretty easy to think about two separate points here and I guess the important thing to highlight is I think both of these drivers which I'll talk about in a second we tend to underestimate.

So the first one is really thinking about the long run return from stock markets and how we see that over that longer period stock markets tend to perform better than lower risk options such as cash. Now I have to say obviously the past returns are not a guide to future returns but this is especially true in the short term, as quite often the relationship between taking on some risk and the return you get can be very different to how it can play out over the long term.

But the short term changes that we see in investments in the markets on a day-to-day basis tends to be what influences our perception, so even if we're considering investing over the long term, as people tend to be when they're thinking about investing, it's that shorter term changes that influence how we feel about investing, so we think that it's potentially a lot riskier than it may be over that longer term once we let time do its thing.

I think the other point to really highlight is about how the value of investments can grow exponentially over time, due to what's called compounding and this is true for any investment that earns a return. It could be that if cash has an interest rate or an investment in stocks and shares.

Now compounding is the effect of the rate of return you get on the return you've earned in in previous periods, so it's interest on interest is a way to think about it, and as time goes on hopefully the more interest you receive, and so the effect of this compounding becomes much larger.

Now we tend to underestimate this effect quite considerably because it's quite complicated mentally to try and work out the effect of that compounding in our heads, and it's much easier to try and think about a very straight line growth effect, and what I mean by that is if we think about an investment that earns 5% return over 10 years, it's very easy to jump to that's 50% over those 10 years.

But actually because of the effects of this compounding you're going to see a 63% return, which is a 26%, almost quarter more than you would have done just from thinking about it in those kind of straight line terms.

I think with cash rates so low at the moment close to zero on many access instant access accounts, the effects of compounding there is negligible, which is why investing is taking some level of risk, it can be much more attractive over the longer term.

CF: Yes, and you mentioned there, and particularly over the short term the perception of risk being a big barrier I guess and a reason why a lot of people don't invest, but given the potential long-term benefits you've just outlined why don't you think more people do it. I was looking at the government ISAs statistics the other day and they're around 22 million adults here in the UK who have an ISA, but the vast majority of those, over 15 million are cash ISAs so what are the barriers that are stopping more people from investing?

RS: So I think as I alluded to and you picked up on I think part of the reason, or a considerable chunk of the reason is down to a misunderstanding of how investments can play a part of anyone's financial plan, which is driven fundamentally by a lack of awareness I think. So I think there are many underlying reasons which are interlinked but I think one of the biggest is the point I made earlier which is the perception of risk associated with investing.

So I think often it's seen as a gamble or a speculative activity, and I think some of that comes down to because of the way it's portrayed in the media, and the way that you see investments highlighted and the things that you're going to read about in the papers generally will be those more speculative investments, and I think people don't necessarily fully understand the effects of reducing and managing risk through what we call diversification which means just spreading out your investments over lots of different companies, geographies, sectors.

I think this perceived risk can mean that people think investments are only appropriate once I have enough cash saved up for all of my life's requirements and therefore it tends to be thought of as an activity for the wealthy.

So if only once you put enough cash saved up for to achieve everything you want then you consider investing, but the reality is if you do that then you're going to be spending a lot more of your time trying to save into cash and not necessarily taking advantage of those longer-term returns that we think are on offer.

And the last thing I'd say is investing can seem very daunting because it's a lot more complex than savings, there's potentially a lot more choice, a lot more options and that can often make it harder and feel like makes you feel and judge yourself a little bit more in terms of are you making the right decision, are you making the right choice, and it can bring a little bit more fear in.

So even if people can see the long-term merit of investing, that doesn't necessarily always make it easier to get invested, so something we come across a lot is that people say well it doesn't feel like the right time to get invested even if even if I'm happy to actually go down that road and have enough awareness and understanding and comfort, but is now the right time.

And the reality is that there's always seems to be some threat to the future of the economy and investment markets that's just the way it is and always will be and so it can always feel uncomfortable taking that first or those first steps into investing.

I think over the short term it may feel like because of like I said the news cycle that risks are really high but actually over the long term those sorts of news stories become less important to investors who are investing over that longer term time period, so I think when thinking about investing and the best time to invest, I like the saying that's ‘because it may not be the time to invest but it's a time to invest’ which is just reinforcing the fact that it's getting in and getting invested over a longer period longest period you can rather than trying to find the best time to start.

CF: And I suppose as we touched upon in or covered off in the introduction with this the ISA millionaire it shows you how almost the earlier you get started and the sooner you get started the more time you've got for your money to grow, so Alina it's probably a good time to bring you in here, and I think for people who are thinking about investing but as Rob's just outlined there's a lot of complexity, some people find it quite daunting and just aren't sure where to begin.

What would you say to them, what should they be aiming to do and how do they get started?

ALINA LOBACHEVA: Yes, so the first thing to do really is to prepare a plan and that may seem very obvious but our lives are so hectic these days that many of us skip this planning step altogether, so it's important to take an hour out of your day or week to create an investment schedule.

CF: And why is that so important, why does it why would you say that's the first place to start with having that that plan?

AL: The plan serves two main purposes really, first of all it allows you to understand how much you can set aside each month, and if you can make any changes to your spending habits to save a little more, and even small changes can make a big difference over time.

So for example a cup of coffee in a shop costs around £2, a takeaway around £6, and an average night out with drinks can cost up to £70, so by removing just one coffee a day, one takeaway a week, and one night out a month you can save £1,800 a year.

And that compounded at 5% per annum gets you an extra £125,000 pounds in 30 years, which isn't really that bad considering how small the changes I've mentioned are. Now you might be thinking I really don't want to be giving up my coffee thank you very much and that's absolutely fine, but I think it's just an illustrative example of how little changes to your budget can make a big difference over time.

CF: It really is, I mean it really does help contextualize it a bit doesn't it, and show how achievable it is to potentially grow your wealth significantly over time even if you don't think you've got much to put away, and those figures you've just run through bring to life the compounding effect and impact that Rob was explaining. Now you mentioned there are two purposes of having a plan so what's the second one?

AL: So the second purpose is really to remove the temptation to time the market by creating a regular and realistic investment schedule and sticking to it. The schedule can always be amended of course but having it helps remove some of that emotional reaction that comes with investing in markets and looking at news flow, so it should make it easier really to focus on the long term and avoid delaying investment decisions or selling everything when markets fall.

So when you're creating your investment plan it's useful to think through different market scenarios and how you may react to these, because that will partly inform how much risk you're willing to take on and therefore what average return you can hope to achieve over the long term.

So for example if equity markets fall by 20% to 30%, and new flow is negative, will you have the composure to stay invested and wait for the recovery? And what if markets fall by 50% for example, but if your composure is low having a high risk 100% equity portfolio really may not be the best option.

So an investment plan should also help you put some colour around your capacity to take risk, because the last thing you really want to happen is to be forced to sell investments at the worst possible moment when the market is falling, only because there are unavoidable outflows that you haven't factored in, for example interest payments, margin calls or even basic lifestyle needs.

CF: So I guess it gets you thinking about understanding yourself a little bit more and really focusing not only how much money you've got to invest, but how comfortable you are with being able to withstand some of the rollercoaster of emotion that might come your way, so once they've got that plan what what's the next thing that you need to do?

AL: So the next stage really is to decide where to invest your cash, and there are so many options out there that it can be quite overwhelming, but luckily today investment platforms do offer a wealth of materials to help you get started. The first thing to think about when creating an investment portfolio is asset allocation, this will determine the expected return you can hope to achieve over the long term and the level of risk you will be taking on to get that return.

Simplistically the more equities you have in your portfolio, the higher your average return should be over the long term, but over shorter periods you will see significant swings in value and not everyone is able to tolerate occasional market sell-offs of over 30%, which is why diversifying across a variety of asset classes is typically the best way forward.

So for example the portfolios we manage for Barclays clients have North American equities, European equities and Emerging Market equities, and these are combined with money market securities, government bonds, investment grade and higher yielding debt. We also include commodities and hedge funds because we believe these further improve diversification, but there's no reason why you can't just stick to traditional asset classes in your own portfolio.

CF: Yes, and I think Rob touched earlier didn't he on that importance of diversification in terms of helping to spread and manage the overall risk, but how do you go about for an individual and somebody listening to this, how do they go about selecting what to invest in with each of the asset classes that you mentioned?

AL: Yes, and since there's so many options available I think the best thing to do is just to highlight a few key principles and considerations. The key principles are diversification which we've referred to a couple of times already, and doing the research. So we talked about investing in a variety of asset classes, but even within asset classes it's worth thinking about investing across different regions, sectors and styles, because a variety of exposures is best.

Also really take time to understand the investments you're buying, so for example if you're buying an ETF which tracks an equity index, read through the fact sheet to understand what you'll be exposed to. At the moment the US equity market tends to include more technology stocks, whereas the UK market has more financials, consumer and resource companies.

Also if you're buying an active fund make sure you understand the investment style and the performance track record of the team, and in terms of key considerations when selecting an investment vehicle think about the cost, exchange traded funds or ETFs are much cheaper than active funds for example, so an active manager really needs to demonstrate superior performance over time to justify their higher fees. In Barclays we use a combination of exchange traded funds, active funds and also direct securities in client portfolios.

CF: Now you manage the money of our wealth clients, and to be eligible for the wealth management service you need to have at least £500,000 to invest, but we do also offer investment options for those with less than that, so you can still do all of this and follow a similar approach on your own.

So firstly we've got Smart Investor which is an investment platform aimed at those who are confident about making their own decisions and want to manage their own investments, we don't offer any advice but there's lots of information and content to help, and you can invest in Funds, ETFs, Investment Trusts, as well as buy shares and bonds in individual companies directly, so follow the same strategy that Alina's just been talking through.

Alternatively if you'd prefer someone else to manage your money because you're not sure where to start or don't have the time we've also got a service called Plan and Invest, and with this you complete an online questionnaire which asks about why you want to invest what you're looking to achieve, and also questions you about you how you feel about risk, and then based on what you tell us you'll then receive an investment plan which is tailored to you, and if you decide to go on and open an account and actually invest, our experts will then choose and manage the investments for you on your behalf.

There's lots more information about all of these services on Barclays.co.uk. But let's come back to the main focus of the conversation today and it's something you mentioned earlier Rob. I think one of the things a lot of people are worried about, particularly if they've never invested before is whether or not it's a good time, and if it's a good time to go into the market.

And obviously stock markets go up and down and the problem is you can never be sure what's around the corner. So Alina, what do you do to remove that worry about market timing and try and take the emotion out of making investment decisions?

AL: This is a really interesting topic and actually a lot of research has been done over the years to understand if it's even possible to add value by market timing, the conclusions of the research are overwhelmingly not in favour of market timing strategies and actually suggest that these are more likely to destroy value over the long term.

And there are really three main reasons why market timing doesn't work, first of all short-term market moves are sentiment driven which means their exact timing and magnitude are unpredictable, so it's really impossible to buy at the very bottom and sell at the very top, as much as we'd like to think that we could do that, no market specialist has ever succeeded in consistently predicting market peaks and troughs.

The second thing to consider is that good and bad days and markets are clustered together, so by trying to avoid the worst days you're very likely to also miss the best days, and historical data shows that missing just a handful of the best days can be very costly, so for example missing as little as 10 good days can reduce your return by half, compared to just staying invested over the same few decades.

Buy and haul strategies work well over the long term because of the compounding effect that Rob talked about earlier, if for example again if you used an ETF to invest in the US market at the worst possible time in 2007, right before the market crash, but held on to your investment until the end of May this year without selling, your nominal compound return would be around 250% or put another way that’s around 9% per annum.

The last challenge for market time is transaction costs because these can really add up quickly when you're when you're trading too often.

CF: So if it's not sensible to try and time the market what is the best approach when it comes to beginning and deciding when to invest?

AL: So the best thing to do is to create a diversified portfolio with an asset allocation that's consistent with your objectives, your willingness and your capacity to take on risk, then invest your excess cash and try to ignore the short-term moves in the knowledge that time in the market is your friend when it comes to the compounding of returns.

And I really want to stress here that having an asset allocation and a repeatable investment process which allows you to make changes to this asset allocation within specific limits and for specific reasons is not the same as trying to time the market.

CF: And Rob, if we bring you back in here, one way to try to avoid the worry of timing the market and whether you're getting it right is to invest small amounts regularly, rather than waiting until you've built up a lump sum and then investing it all at once, can that be a good thing to do?

RS: Yes, and indeed and for most people investing regularly rather than waiting to save up a lump sum is the best option as you can get invested as soon as possible, maximizing that time we've talked about, that time of being in the market and time to earn a return.

If you are in a position, the fortunate position I guess if you've already saved up cash and have a lump sum that potentially you could think about investing, and are worried about investing it all perhaps because markets could fall as well as rise as well in the near term, then breaking this into smaller investments and making these over a regular period may be a good strategy because whilst it does not guarantee returns as Alina has said and we've talked about before thinking about and understanding what's likely to play out in the short term in markets is very difficult, so we don't know that it's definitely a good strategy for giving you returns but from an emotional point of view it can make it much easier to get started knowing that you're not putting not everything or all of that lump cash lump sum in at one go.

And so I guess if markets do fall then potentially you buy some at a lower price and it's what we call pound cost averaging, however the flip side is that if markets do continue to rise then you're also buying at an increased price so it could go either way, but it can often give you the comfort needed to get invested then that's a good thing.

One thing I would just mention is that if you're going to do that, I would highly recommend looking to set up automatic regular investments, because then then that takes those decisions away from you, you don't have to continuously make that decision is it the right time this month. is it the right time, is the right time, you can just it to occur on a monthly basis and then not have to engage with it again, which is almost always going to be better for your emotional state.

CF: Yes, and its habit forming, where as well isn't it the same ethos as saving regularly and setting up a standing order to save money every month, it's the same concept I guess. Rob, Alina thank you so much for that it's really interesting and hopefully we'll have given people some inspiration and ideas on how they can either get started if they don't already invest, or potentially make some changes to how they invest if it's something they already do to perhaps diversify a bit more because we've heard a lot about the importance of that.

And Alina I think the example you gave about the impact of compounding really will definitely stick with me it's a great reminder of the importance of time when it comes to investing and I think I might even take a look at my own bank statement to see what I can do myself to put a bit more money away each month for the longer term, there's bound to be ways I can spend less and invest a bit more.

Thank you all too for listening today I hope you found it helpful and that we've provided you with some food for thought. I'll be back again next month, in the meantime I hope you enjoy the rest of your day, thank you.

Disclaimer: all investments can fall as well as rise in value and their past performance is not a reliable indicator of future performance this podcast is not a personal investment recommendation