Weekly outlook

Use, don’t lose your ISA allowance

By Tom Stevenson, 18 February 2009

Five reasons not to miss the deadline in 2009

As the clock counts down on the rest of the 2008/09 tax year, investors will be encouraged to use and not lose their ISA allowance. Many, after the dismal stock market performance of the past year, will not be jumping at the chance to top up their portfolio but they should think carefully before passing up the opportunity. Since the beginning of the current tax year in April 2008, the FTSE 100 index has fallen by 30% and, with the exception of government bonds, there have been few places to hide. After such a difficult year, it is only human nature to want to avoid being burned twice.

"Invest when shares are low and no-one is interested in the stock marke" Tom Stevenson

Human nature, honed on the savannah many millennia ago, is fantastic at helping us avoid danger. But the tools that helped us survive in a risky physical environment are less good at helping us prosper in the quite different environment of the financial markets.

In financial markets we must learn to relax when the economic danger signs are flashing red and run for safety when the outlook appears least threatening. In other words we should invest when shares are low and no-one is interested in the stock market and hold back when everyone else is flocking to invest.

Look at the chart below. It shows annual subscriptions into PEPs and ISAs over the years and it makes a clear, if slightly disheartening, point. People instinctively want to top up their ISAs when the market is near a peak but they keep their wallets firmly closed when the market is in the doldrums.



 At the top of the dot.com bubble, ISA subscriptions were around twice as high as they were at the bottom of the subsequent bear market in 2003. Many investors bought just in time to suffer the fall in markets and then failed to benefit from the four-year bull market between 2003 and 2007.

If history repeats itself 2009 may be another year in which investors think about using their ISA allowance but decide that, on balance, they’re quite happy to lose it this time around. For five reasons, that is likely to be a mistake.

1. Recent research by Fidelity has shown that a higher-rate taxpayer could achieve a real return (ie after inflation) up to 83% higher by wrapping their investments in an ISA than leaving it exposed to the tax man.

In our study, we assumed that an investor had built up a tax-free fund of £50,000 and then tracked what happened to that savings pot over a ten year period inside and outside of an ISA.

The different returns are striking. For example, an investor in a UK fixed-interest fund earning 5% a year would achieve an investment growth on their £50,000 starting capital of £17,192 in an unprotected fund but £31,445 within an ISA.

With personal tax rates only likely to head one way as this and future governments look to restore stability to the government’s finances, the advantages of this wonderful tax break are only going to increase over time.

2. Even without the tax advantages of an ISA, there are a number of investment-related reasons why the 2009 season could be a profitable time to use your allowance. The first of these is illustrated by the chart below, which shows how extended periods of stock market underperformance (in this case ten years) are often followed by periods of outperformance.

Last year marked the end of the first ten-year period since 1982 in which the real total return from shares (after inflation and including reinvested dividends) was negative. There have been two big clusters of “lost decades” in the past century and both times they were followed by several years of good performance.

Obviously there’s no guarantee that this pattern will be repeated but history suggests that buying after an extended period of poor performance stacks the odds in your favour.



3. Consumer sentiment is very weak at the moment, as job losses take their toll on people’s willingness to spend. On the face of it this might suggest that now is a bad time to invest in the stock market but history shows that the market has an uncanny ability to look through this sort of gloom to the recovery beyond.

An analysis of the returns from investing at extremes of consumer confidence shows that buying when animal spirits are high results in much lower returns than when everyone is depressed about the outlook.

4. Fidelity has long argued that investors should remain invested through the stock market cycle both because of the high cost of missing the best days in the market and because of the impossibility of timing the market to capture these best days and avoid the worst ones. Over the last 20 years, an investor who reinvested his or her dividends and remained invested throughout the period would have enjoyed an annualised return of 7.3%. But the same investor who had had the misfortune to be out of the market on the 100 best days in that 20 year period would have lost 8.4% a year. While an investor trying to time the market might be lucky enough to also miss some of the market’s worst days, successfully dipping in and out of the market in this way is a matter of pure chance.

5. Something very similar happens for investors who miss the early stages of a bull market. Fidelity research into the UK’s biggest stock market rises since 1987 shows that an investor who joins in 100 days after the start of a bull market achieves a significantly lower capital gain than one who was invested throughout. For example, an investor who invested throughout the bull market that ran from 2003 to 2007 would have achieved an annualised return of 16% while an investor who missed just the first 100 days of this four year run would have achieved an annualised return of just 12%.