Late February and early March is when a host of ads and newspaper, magazine and blog articles about ISAs start to appear. The tax year ends on 5th April and after that any unused portion of our £20,000 ISA allowance is lost. If you’re one of those people who leaves it to the last minute, you could be missing out on several advantages that come with paying into an ISA throughout the year and not waiting until the end of the tax year.
Drip feed your ISA
The first advantage to staggering smaller, regular ISA payments over the whole tax year is that it builds the positive habit of a steady routine. Once we get into a routine of doing something it becomes less of an effort to maintain the habit and not doing so can nag at us. When the habit is a good one, that’s an advantage.
You won’t miss your ISA contribution and it helps build the mental approach of investing as an ongoing, long-term activity with little connection to short-term market conditions.
Cost pound averaging
The term sounds complicated, but all cost pound averaging means is investing smaller sums over time to a staggered but relatively regular schedule. Or drip feeding. The term cost pound averaging is used because drip feeding investments regularly throughout the year and over several years, evens out the cost of investments.
In a falling market the same investments become cheaper each month and in a rising market more expensive. Investing smaller sums regularly means the cost of your investments should eventually even out at their long-term average, hopefully smoothing out some of investing’s ups and downs.
By ignoring temporary conditions and sticking to monthly ISA payments you also won’t run the risk of trying to time your entry – an approach that can easily go wrong.
Over the long term, compound returns add value to an investment portfolio. So not delaying ISA investments until deadline day helps improve compound returns (should the markets go up).
The concept is simple. When your investments deliver positive returns and you re-invest those returns, keeping them in your ISA, they grow your capital. If you invest £10,000 into your ISA on deadline day and it returns 5% over the year, your balance becomes £10,500.
The next year any returns will be a percentage of £10,500 and not £10,000. If they are 5% again (less than the 25-year average for the FTSE 100 with dividends re-invested), that’s £525. Your balance is now £11,025. 5% of that will now be £551.25 the next year.
Over years this builds significantly. A £5,000 investment in the FTSE All Share in 1986 would have grown to £28,357 by the end of 2016 if returns were withdrawn and not reinvested for compound returns and before all fees, costs and taxes. If you’d let your investment benefit from compounding, you would have had £88,396 for the same period.
If you wait until the ISA deadline is just around the corner, you miss out on any returns your investments would have generated over the rest of the year. Of course, the market doesn’t go up every year but historically it has more often than not.
So by drip feeding your ISA every year you should slightly improve your compounded returns. And as we’ve seen, over 20 or 30 years this can build up to make a real difference in favourable markets. Next year, why not give it a go?