IFISA: understanding the risks vs the returns

It’s widely recognised and understood that any investment also involves an element of risk – the threat of not getting all or some of your money back, or, at least, of an investment performing significantly worse than anticipated.

As a rule of thumb, the better the potential rate of return that an investment offers, the higher the risk is likely to be. 

In simple terms, putting money in a bank deposit account will only earn you low rates of interest, but your money is safe, and even in the unlikely event of your bank going bust, the government guarantees the value of your deposit up to £85,000. 

On the other hand, if you put your money into a start-up technology company, you have the opportunity of rich returns, but also the chance of losing a chunk of your original investment.

What is your attitude towards investment risk?

People have different attitudes to risk when it comes to investing. 

For one thing, some people are generally more adventurous or more optimistic and so their temperament makes them more open to investment risk. 

A person's attitude to risk also varies according to their circumstances. Somebody who is relatively wealthy might have funds they can afford to lose and so may be inclined to put them in higher risk investments. 

However, another individual with limited money may be less inclined to risk it. Similarly, somebody approaching retirement could well be more inclined to protect the value of their savings, while a younger person - calculating that they still have time to make up for losses - may lean towards a higher risk/higher growth strategy.

It’s important, before you embark on any form of investment, that you understand your own attitude to risk and can choose assets accordingly.

When it comes to the risks vs returns of IFISAs, it’s useful to look at the broader category of ISAs first.

What are the risks vs the returns of Cash ISAs?

With a Cash ISA, your investment is in the form of cash, and you receive interest on it - as you would in a bank deposit account - but that interest is tax free.

It’s the same with a fixed-rate Cash ISA, except that here you commit to locking your money away for a fixed term - typically one to five years - in return for a fixed rate of interest. This fixed-rate of interest will usually be higher than you can get in a simple Cash ISA.

A Cash ISA is the most secure, or lowest risk ISA. You don’t need to fear a company going bust or doing so badly it can’t pay a dividend as with a stocks and shares ISA. But, you will only earn around the market rate of interest, which at the moment is at an all time low. 

A fixed-rate ISA will pay a better rate of interest, but there’s a slightly greater risk in that inflation might rise, so the value of the capital is eroded. 

Read more: Choosing between a Cash ISA and an IFISA

What are the risks vs the returns of Stocks and Shares ISAs?

With a Stocks & Shares ISA, your money is invested in company shares and government and corporate bonds. You can earn a return from dividend and interest payments, as well as any capital gains resulting from a rise in the value of the investments.

The rates of return will typically be higher than those in either of the two types of Cash ISA, but that’s not always the case. Investors can suffer serious short term losses if individual companies invested in do badly, or if the stock market loses value.

What are the risks vs the returns of IFISAs?

In terms of risk vs return, IFISAs sit between Cash ISAs and Stocks and Shares ISAs. 

IFISAs usually pay a better rate of return than a Cash ISA, while having a greater element of risk. On the other hand, IFISAs can be more secure than Stocks and Shares ISAs, but they tend to pay a lower rate of return. 

Also, property bonds held in an IFISA may be secured against the asset whose acquisition or development they were issued to fund. 

However, even if an IFISA is asset-backed, an economic downturn could affect returns and you may not get back the amount invested. 

In the event of default, the security held doesn't guarantee the return of your capital. Enforcing your security may also take time, and your returns may be delayed. 

It’s also important to remember that IFISAs are not covered by the Financial Services Compensation Scheme (FSCS). 

IFISAs can form a valuable part of a diversified portfolio - another crucial aspect to consider when managing the balance between risk and return. 

Conclusion

To summarise, a spread of investments across different asset classes, industrial sectors and geographical areas will limit your exposure to loss, and the variety of ISA accounts available present great opportunities for tax-efficient diversification.

Every investor has a different risk profile and should consider this along with taking advice from an independent financial advisor before making any investments. 

Originally published 7th August 2019, updated 9th January 2020.