If you’ve made the decision to invest £500 in an ISA every month, I reckon you’re serious about building a pot of money for the future. The next step is to make sure the £6,000 you’re saving each year works hard for you.
So, I wouldn’t entertain putting it in a Cash ISA, for example. The interest rates are just too low, and even if you compound your gains by reinvesting all the interest, you’ll probably end up falling behind inflation.
Compounding investments
In other words, you could save and compound for years, only to find the spending power of the money you’ve accumulated ends up being lower than it was when you first put the money in. To me, that’s the opposite outcome from the one we want when we invest money – we want our money to grow, both in absolute terms and in its spending power.
I’d go for a Stocks and Shares ISA instead. Over the long haul, share-based investments can do well. And that’s not surprising when we look at the dividend yields on offer today. For example, in the FTSE 100 index, we’ve got quality stocks paying dividends around 5% and above, such as GlaxoSmithKline, British American Tobacco, SSE and others.
The great thing is you can take your dividend income from your shareholdings and plough it back into more shares to compound your investments. The process is like what happens when you keep your interest in a cash account in the bank. But the yield from dividends can be higher than cash account interest rates. Potentially, then, your investment may compound faster with shares.
But share prices can move up and down, which means the capital amount of your investment will fluctuate too. Of course, that doesn’t happen with a cash account because the capital in the account never falls in value. It just grows a bit when the interest is added. And I reckon the volatility with share prices may put some people off investing in shares and share-backed vehicles.
3 ways to get the most from your investments
But if you shun shares because of volatility, I reckon you run the risk of missing out on the higher gains available over time. Because the stock market, in general, tends to rise over the long haul, and you’ve also got that dividend income to look forward to. Luckily, there are ways to handle the fluctuations and strategies that help to dial down risk.
For example, I’d start by targeting the shares of companies with high-quality underlying businesses. And, secondly, I’d make sure my investment timeline is long. Over long periods of time – say decades – fluctuations in share prices can start to look insignificant if the underlying businesses keep performing well.
A third way to smooth out volatility and dial down risk is to use the principle of diversification. And one way of achieving comprehensive diversification across many underlying shares is by investing in managed and passive funds.