Following this year’s stock market crash, it’s easy to see why investors have rushed to open Cash ISAs.
However, while these products might look as if they can provide protection in uncertain times, over the long term, they could destroy your wealth.
Today I’m going to explain why, and what investors can do to stop this from happening.
Cash ISA drawbacks
Interest rates available on Cash ISA products have plunged this year.
At the beginning of the year, investors could have achieved an interest rate of 1.5% per annum on their money. Today, they would be lucky to get more than 0.9%.
This is the biggest drawback of these products. Over the past 10 years, the rate of inflation has averaged 2% per annum. This suggests that an interest rate of 0.9% means investors are receiving a real interest rate (after inflation) of -1.1%.
To put it another way, opening a Cash ISA today may erode your wealth over the long run.
That being said, every investor should have some of their money invested in cash in case of emergencies. So these products play may still have a valuable role to play in some investors’ portfolio.
Nevertheless, if you are serious about growing your wealth, there’s a much better alternative to the Cash ISA out there.
A perfect alternative
The best alternative to opening a Cash ISA could be to open a Stocks and Shares ISA.
Stocks and Shares ISAs allow investors to hold cash and stocks and shares. Many companies support dividend yields significantly above the best Cash ISA interest rates on the market at the moment.
For example, the average dividend yield of the FTSE 100 is around 3.6%. That is three times higher than the best Cash ISA interest rate.
Stocks and Shares also offer the potential for capital gains. Over the past three-and-a-half decades, the FTSE 100 has produced an average annual return for investors of around 8%. This has come through a combination of income and capital gains. It is impossible to achieve capital growth with a Cash ISA.
Building a portfolio
The best way to capitalise on the wealth-creating power of the stock market is to build a diversified stocks and shares portfolio.
Investors can do this with a basket high-quality blue-chip stocks, investment funds, tracker funds or investment trusts. All of these instruments provide different ways to gain exposure to the market.
I would use a combination of all four. This would allow me to build a well-diversified portfolio of stocks and shares across different markets and sectors.
The diversification would help capitalise on the long-term market performance while minimising losses if something went wrong.
While investing in the stock market is always going to have a bit more risk than owning cash, diversification, and the potential for higher returns should more than make up for this risk over the long run.