By Richard Evans
The Isa season is upon us again: wherever you look there in an advertisement from a financial firm trying to persuade you to use your annual allowance of £7,000 to invest in one of their Individual Savings Accounts before the end of the tax year on April 5.
There are plenty of tempting excuses to avert your eyes; after all, the rules are complex, the choice is bewildering and stock markets can fall without warning, while £7,000 is a lot of money to find in one go. But it would be a mistake. Everyone can benefit from a Isa, as long as they take a little time to consider their needs, decide on their attitude to risk and do some homework on the products available.
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"One of the first rules of financial planning is always to have some cash set aside in case something goes wrong," says Mark Dampier of Hargreaves Lansdown, the financial adviser and stockbroker. After all, redundancy, sickness or a large household repair bill can strike at any time. "As a minimum, try to have three months' salary available to meet these emergencies. But some of this money can be in a cash Isa - they usually allow instant access to your money without penalty and pay good rates, free of tax," he adds.
One of his recommendations is the Direct Isa from National Savings & Investments, which currently pays 5.8 per cent. As with all cash Isas, the most you can invest is fixed by law at £3,000 a year, while this account imposes a minimum investment of £1,000. But you are allowed to move your cash Isa to another provider if your original choice falls down the best-buy tables; there is sometimes a small charge to switch.
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Only once you have this cash safety net in place should you consider other investments such as shares, says Mr Dampier. "If you buy shares you should be thinking in terms of a minimum of five years - preferably 10," he adds. The reason for this is that while shares can and do fall suddenly, and drops of 20 per cent are not unknown, they tend to rise in the long term. A share price graph might show plenty of peaks and troughs over a 10-year period, but there is a good chance that the overall change will be a healthy gain.
If the thought of such gyrations brings you out in a cold sweat, however, investing in shares in probably not for you. "You can test your own attitude to risk very easily," says Paul Banfield of Best Advice Financial Planning. "Ask yourself: will I be upset if I lose money or will I think, that's okay, the shares will recover. If owning shares will keep you awake at night it's not worth doing it."
Some commentators have suggested that, even if you decide to invest in shares, an Isa is not always the right way to go about it. Pointing out that the tax breaks are less favourable than they once were, they say Isas are not worthwhile for basic-rate taxpayers. "I disagree," says Mr Banfield. "We all pay capital gains tax on any profits over £8,800 in one year. If you put £7,000 into an investment fund and it quadruples in the space of a few years - which can happen - you will be hit with a tax bill when you cash it in. Buy the same fund as an Isa and there is no tax to pay."
If you have already taken out a cash Isa this year the most you can put into a stocks and shares Isa this year is £4,000, even if you don't use the cash Isa's full £3,000 limit. If you don't take out a cash Isa this year you can invest up to £7,000 in a stocks and shares Isa.
This is where making a choice gets harder, as there are hundreds of these Isas on the market. You could, of course, ask for help from an independent financial adviser.
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You can choose to pay directly for such advice or allow the adviser to receive a commission on the product that you buy. But there are some guidelines to follow if you prefer to make the selection yourself.
"Buy your Isa from a fund supermarket. Buying straight from the Isa manager is madness," says Mr Dampier. Fund supermarkets - which include Skandia, Cofunds, FundsNetwork and Mr Dampier's own firm, Hargreaves Lansdown - are online shops that allow you to choose from a large number of Isas from the major fund managers. As well as providing a huge choice of products, fund supermarkets make administration much easier - a big benefit if you have a number of Isas from different years or switch from one fund to another - and are usually cheaper than buying direct.
"This is an example where cutting out the middleman costs you more," says Mr Dampier. "Fund supermarkets often waive the initial charge that fund managers impose, which can be around 5 per cent. But the administration that they carry out on your behalf is also a huge aid to investment performance, as you can move from one fund to another as you wish, usually just by making a phone call or going to the web site." Switching from one stocks and shares Isa to another if they are held directly with the fund managers involves a lot of paperwork and takes time, encouraging investors to stick with funds that may not be performing as well as others on the market.
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When it comes to choosing the actual funds to invest in, Mr Dampier has this advice: "Find out what other people are buying and avoid it." Holding up as an example the rush into commercial property over recent years, he explains that investors' enthusiasm for a particular asset always pushes up the price, so that gains for subsequent buyers are harder to achieve, while returns on the investment in the form of dividends are lower in proportion to the price paid.
"I would also avoid overly specialised funds, such as those focused on India or China. Global emerging markets funds are a little safer, but I would prefer to recommend an equity income fund such as Jupiter Income," he adds. Equity income funds pick companies that pay decent dividends, which can help to offset any fall in the share price. And as these companies' dividend yields are often high because the business operates in a temporarily unfashionable sector, there is frequently scope for capital growth too as the stock market comes to realise the true worth of the shares.
But long-term Isa investors can also be too risk-averse, says Mr Dampier. "They hear that bonds, for example, are low risk and buy a bond fund. But 'low risk' doesn't mean 'no risk'. There is a big chance of the world's credit boom going wrong - and then bond funds would suffer. I think a better way to be prepared for the worst is to pick an experienced fund manager. Neil Woodford of Invesco Perpetual, Adrian Frost at Artemis and Nigel Thomas of Axa Framlington have all been through bear markets and will see you through the bad times.
"But the absolute best way to invest in an Isa is to save a regular amount each month. This way you are not out of the market when it is climbing" - a famous risk for those who try to time the market - "but you also benefit when share prices fall, as you get more shares for your £250 a month, or whatever you choose to save." This effect is known as pound cost averaging."I would even say it is better if share prices go down for the first few years of a regular savings plan as you get more for your money," says Mr Dampier.
"This approach is often overlooked but it is a fantastic way of accumulating money. You can even put your entire £7,000 allowance into a fund supermarket before the deadline as cash - this is not the same as a cash Isa as you will pay tax on the interest - and choose the best fund at your leisure, then drip-feed the money into it over the next year."
New rules on Isas will come into force in April 2008. The main change is that you will be able to switch money already invested in a cash Isa to a stocks and shares Isa, giving you more flexibility to choose when to enter the equity markets. Switching in the other direction, from stocks and shares to cash, will remain prohibited. The rules will also be simplified, with the distinction between mini and maxi Isas being abolished.
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