With just three months to go before the current tax year ends, it's an important point to ponder.

The latest available official figures¹ show that cash ISAs remain by far and away the most popular type of ISA in the UK – and it's a preference that frustratingly appears to have grown, despite record-low cash returns.

I say “frustratingly” because it's at the expense of stocks and shares ISAs, which offer potentially higher returns and can give investors a better chance of meeting their long-term goals.

In all, there were 22 million people with adult and junior ISAs at the end of the 2018-19 tax year, with just over 12 million of these accounts attracting new money during the period. Cash ISAs accounted for more than three quarters of these subscriptions, which is more than was the case in 2017-18.

Uncertainty

Why that was is unclear, although one can speculate about people's motives given the high levels of economic uncertainty whipped up in the wake of the Brexit referendum as former prime minister Theresa May struggled with a thin parliamentary majority.

And that uncertainty can only have grown last year due to Covid-19.

Make no mistake, cash is an essential component of any household's savings. It's the first line of defence if anything goes wrong. So if you haven't got the right cover for that proverbial rainy day, you really shouldn't be investing at all.

But, over and above that safety net, are the country's ISA holders getting the most out of their savings by sticking with cash?

The answer depends on what you're hoping to achieve with this money – your goals – because once you know that you'll be better positioned to weigh up the potential risks and returns.

For example, if you're getting married in six months' time – that is, if your goal is in the very near future – it makes sense to keep your money somewhere safe, like in a bank account. After all, you don't want to put the value of your capital at risk by investing it in markets that can go down as well as up and risk messing up the big day.

Safety comes at a cost

But the problem with the safety that comes with cash is that it tends to give you a lower return – not least when interest rates are at rock bottom, as they are now. And the lower your returns are over the long term, the more likely they are to be eroded by inflation, which means your money may actually be worth less in the future.

To illustrate that, consider the chart below. The blue line shows the returns you would have received, using a proxy, from holding cash on deposit since the start of 1999. Not great, but not too bad.

However, the red line shows those returns after accounting for inflation. It demonstrates the extent to which inflation eats into the returns from cash held on deposit over the long term – especially when, as has been the case for much of the past ten years, inflation is higher than interest rates.

Cash returns before and after the effects of inflation

Cash returns represented by the ICE Libor 3-month sterling rate; inflation by the UK Retail Prices Index.
Source: FactSet as at 30 June 2020. Past performance is not a reliable indicator of future returns.

So if your goal is further away – say 10 or 20 years or longer, such as your retirement – then you need to give your cash a better chance to outpace inflation. In this scenario, keeping it in a cash ISA is less likely to be the answer compared with investing it in a stock and shares ISA.

An annual net return of just 5%, for example, would have turned £10,000 into almost £29,000 over the same period shown in the chart.

Of course, the value of your share investments can go up and down, putting your capital at risk. But because of the longer time frame you have more scope to ride out any adverse moves and have a better chance of reaping the superior long-term rewards that have historically accrued to shares. What's more, you can manage those risks by ensuring your investments are diversified, either by investing in a fund of many shares rather than a few individual shares or investing in a multi-asset fund that combines shares with lower-risk bonds.

So why should you invest in a stocks and shares ISA rather than in a cash ISA? Ultimately, it depends on what you want to do with the money. What's fair to say, though, is that if your ISA savings are more than just a cash buffer, then you probably have a better chance over the long term of beating inflation and growing your wealth with a stocks and shares ISA.

 

¹ Includes junior ISAs. For a more in depth look at the ISA data got to: https://www.gov.uk/government/statistics/individual-savings-account-statistics