It’s safe to say that cash ISAs have had a resurgence over the past couple of years, as a result of sharp rises in interest rates as the Bank of England tried to tame inflation.

However, the Bank has kept interest rates on hold at 5.25% since August 2023 as inflation has come down sharply from its peak¹.

That means some savings rates are now higher than the rate of inflation – meaning savers are earning a positive real (after inflation) return on their savings.

However, our economists think interest rates will start coming down from the middle of the year, so savings rates are unlikely to remain as high as they are now. 

We don’t think this fundamentally changes the role of cash. Everyone should have some emergency cash savings – that pot of money we should all keep aside for unexpected spending or income shocks such as a redundancy (one rule of thumb is to keep three to six months’ worth of outgoings in a bank account).

However, there are still good reasons to consider shares in your individual savings account (ISA) if you are investing for longer-term goals (beyond five years).

Shares have historically delivered higher returns than cash, after inflation, over the long term, as we explore below. However, you need to be comfortable with the risk that share prices could fall as well as rise and you may get back less than you invested.

Here are some of the reasons to consider a stocks & shares ISA over a cash ISA, once you have your emergency savings in place.

Positive outlook for long-term investors

The return to a more ‘normal’ environment for interest rates (where they are above the rate of inflation) should be just as positive for other assets such as shares and bonds², as well as cash. It should help investors achieve their financial goals, because it will set a solid foundation for long-term returns from bonds and shares over the next decade.

We forecast that UK shares will return 4.7%-6.7% annualised³ over the next ten years. For global ex-UK shares, we expect annualised returns of 5.1%-7.1% over the next decade⁴.

The outlook for bonds (which can play a key role in your portfolio by smoothing out returns from higher-risk assets such as shares) is also better than it has been for many years.

We now expect UK bonds to deliver annualised returns of around 4.4%-5.4% over the next decade, compared with the 0.8%-1.8% we expected at the end of 2021, before the rate-hiking cycle began. Similarly, for global ex-UK bonds, we expect annualised returns of around 4.5%-5.5% over the next decade, compared with a forecast of 0.8%-1.8% two years ago⁵. However, do remember that these projections do not reflect or guarantee future results.

Cash remains at the mercy of inflation

Despite inflation now being lower than the rates on some savings accounts, the long-term picture is that shares have historically delivered a better return than cash once adjusted for inflation.

The chart below shows the value of a £10,000 investment in cash and shares since the end of December 1998, both before and after inflation. The performance of shares is represented by a global stock market index. Although it’s not possible to invest directly in an index (you can only do so through a fund, which involves costs) it does give you a sense of the bigger picture.

Returns from £10,000 in cash and shares, before and after the effects of inflation

Past performance is not a reliable indicator of future results. Notes: Cash returns represented by the UK Sterling Overnight Index Average benchmark (SONIA), global shares by the FTSE All-World Index with dividends reinvested; inflation by the UK Retail Price Index. SONIA reflects the average rate of interest banks pay to borrow overnight.

Source: Factset, Vanguard calculations based on period 31 December 1998 to 31 December 2023.
 

It is also worth noting other limitations of having too much of your savings in cash. The best savings rates on the market tend to require you to lock in your money for a certain period of time or place limits on your withdrawals.

You get rewarded for the risk

As we have already highlighted, cash may look attractive (at the moment!) but shares have a better long-term record when it comes to outpacing inflation.

Investing in shares means benefiting from something known as the ‘equity-risk’ premium. This is the idea that, because share prices are more volatile than other investments, investors should be rewarded for bearing this additional risk.

So, if you can bear the increased risk (because you have a longer time horizon, for example), then it could be worth considering a stocks & shares ISA.

It’s also worth remembering that much of the trade-off between risk and potential reward can be managed by investing through funds, which can diversify your investments across thousands of different shares and/or bonds.

Meanwhile, investors who make regular contributions to their ISAs benefit from the effect of compounding (where you earn a return on your return).

The long-term impact of regular contributions to a stocks & shares ISA can really accelerate you towards your long-term goals.

How to invest

Finally, a quick reminder that £20,000 is the most you can currently invest in an ISA in a tax year, which runs from 6 April to 5 April the following year.

This overall ISA allowance covers the different types of ISA, so if you invest £10,000 in a cash ISA in a single tax year, you can only invest a maximum of £10,000 in your stocks and shares ISA in the same year.

As the limit refreshes in early April each year, you can’t carry over any unused allowance into the following tax year. So, whether you choose a cash ISA and/or a stocks & shares ISA – make sure you don’t lose out on any unused allowance.
 

¹ Inflation peaked at 11.1% in the 12 months to October 2022 compared with 4% in the 12 months to December 2023. Source: Consumer price inflation, Office for National Statistics.

² Bonds are a type of loan issued by governments or companies, which typically pay a fixed amount of interest and return the capital at the end of the term.

³ Annualised returns show what an investor would earn over a period of time if the annual return was compounded (i.e. the investor earns a return on their return as well as the original capital).

⁴ Source: Vanguard projections generated by the Vanguard Capital Markets Model® (VCMM) as at 31 December 2021 and 30 September 2023. Note: Figures are based on a 2-percentage point range around the 50th percentile of the distribution of return outcomes for shares. All projections are in pounds sterling. Benchmarks used for asset classes: UK equities: MSCI UK Index; global ex-UK equities: MSCI AC World ex-UK Index. Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.

⁵ Source: Vanguard projections generated by the Vanguard Capital Markets Model® (VCMM) as at 31 December 2021 and 30 September 2023. Note: Figures are based on a 1-percentage point range around the 50th percentile of the distribution of returns for bonds. All projections are in pounds sterling. Benchmarks used for asset classes: UK bonds: Bloomberg Sterling Aggregate Bond Index; global ex-UK bonds (hedged): Bloomberg Global Aggregate ex Sterling Sterling Hedged Bond Index. Hedged means hedged back to local currency to manage currency fluctuations. Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.