An understanding of any investments has to include a grasp of the relationship between risk and return.
Clearly, any investor is looking for a return on their investment, otherwise they might as well keep their money under the mattress. It’s widely recognised and understood that any investment also involves an element of risk – the threat of not getting some or all 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.
Attitudes towards investment risk and reward
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. But people’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, whereas 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.
The risk and reward of different types of ISAs
When it comes to the risk versus reward of IFISAs, it’s useful to look at the broader category of ISAs, of which they’re one type.
ISAs, or Individual Savings Accounts, were introduced in 1999 to encourage saving and investment. They offer generous tax breaks, so that you can invest up to £20,000 a year through an ISA without paying tax on the income or capital gains.
There are now seven types of ISA accounts. We’ll just look at two: Basic ISAs and IFISAs.
Basic ISAs can be divided into: Cash ISAs, Fixed Rate ISAs and Stocks & Shares 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 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, which 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 or the state of the stock market. But, you will only earn around the market rate of interest which, at the moment are historically low. A Fixed Term 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.
With a Stocks & Shares ISA, your money is invested in company shares and in 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, as we’ve seen, that’s not always the case and the investor can suffer serious short term losses if individual companies invested in do badly or if the stock market loses value.
IFISAs, or Innovative Finance ISAs were set up in 2016 in response to the growing interest in the peer to peer lending market and more investors taking advantage of the opportunities offered by high growth businesses raising funds on online platforms.
With the introduction of IFISAs, they could use some, or all, of their annual ISA investment allowance to lend funds through the peer to peer lending market and buy other debt based securities, getting the ISA tax advantages. These can include property bonds, issued by a company to fund property projects, including the purchase of land or properties, development finance and planning finance. They are typically held for fixed period, of say to two to five years and carry a fixed rate of interest, which can be paid to the holder regularly or rolled up to be paid over at maturity, along with the face value of the bond.
Risk and returns of IFISAs
In terms of risk versus return, IFISAs sit between Cash ISAs on the one hand and Stocks and Shares ISAs on the other. They’ll usually pay a better rate of return than a Cash ISA, while having a greater element of risk, but they can be more secure than a Stocks & Shares ISA, even if 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 take time and your returns may be delayed. Investment isn’t covered by the Financial Services Compensation Scheme (FSCS).
Finally, when managing the balance between risk and return, it’s important to remember diversification. A spread of investments across different asset classes, industrial sectors and geographical areas will limit your exposure to loss. The variety of types of ISA accounts available presents great opportunities for tax efficient diversification and IFISAs can form a valuable part of a diversified portfolio.