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Common ISA Misconceptions Part V: Jargon Busting

'Is an Individual Savings Account actually a savings account?' and other questions ISA-related terms may provoke

Morningstar.co.uk Editors 18 February, 2011 | 2:23PM

On our final day of lifting the veil on common ISA misconceptions, we are addressing some of the ISA-related jargon investors might find particularly confusing and generally unhelpful.

Catch up on earlier parts of our week-long Common ISA Misconceptions feature if you are not clear on the basics of ISAs, the tax benefits of ISAs, who is eligible to invest through an ISA, or how you can transfer money between ISA types and providers.

1.ISA
It is not (in this case) the Italian Space Agency, the Israeli Securities Authority or the UK Independent Safeguard Authority.

It is an Individual Savings Account, at least in the world of investment. While this meaning of the ISA acronym provides an insight into how ISAs can make for a prudent investment tool, the name is not exactly helpful. The words ‘savings’ and ‘account’ could suggest that ISAs are similar to bank savings accounts and this is only partially true. Only half of the annual ISA allowance (£10,200 in 2010/2011, £10,680 in 2011/2012) can be held in cash. The rest, or all of it, can be put towards a stocks and shares ISA. The name also does not advertise its main advantage—that it enables you to save or invest without incurring taxes on your income or returns.

Mornigstar.co.uk editor Holly Cook suggests the term Tax-Efficient Account might be more helpful, as in “The investments in my TEA have gained over 10% this year, I’m glad it’s tax free. Fancy a cuppa?”

2.Stocks and shares ISA
It is not an ISA that only allows you to invest in the stock or shares of a listed company.

It is an ISA vehicle that allows you to invest in shares of listed companies, OEICs, closed-end funds, exchange-traded funds, corporate and government bonds and insurance policies. There are exceptions, however. Most OEICs and CEFs are eligible, but ETFs’ eligibility depends on where they’re listed; AIM-listed stocks do not qualify (though you could invest in a fund that has AIM holdings); non-EEA government bonds are not accepted (again, you could always opt for an emerging markets debt fund if you’re keen to tap into these markets).

The terms Investment TEA and Savings TEA might be more helpful.

3.Pound-cost Averaging
It is not the average pound cost of your Sainsbury’s shopping basket.

It is a term that refers to a specific investment strategy. In summary, it enables an investor to smooth out the peaks and falls of the market by drip-feeding assets at regular intervals, thereby investing in both times of market affluence and market poverty, while keeping some assets back in cash. The benefits include its propensity to reduce volatility and the good investor behaviour (regular investing) that it enforces. Having a strict investment discipline prevents rash decisions such as quickly withdrawing funds when the markets are going down or contributing a lot when markets are going up. Essentially, it is a strategy that can prevent investors from themselves. However – as with any investment strategy – it has certain risks. It may mean that when markets are going up, an investor relying on pound cost averaging will gain less than an investor who manages the near-impossible task of timing the markets.

The term risk/return reduction might be more helpful.

4.Compound Interest
It is not an amalgam of all interest rates of any savings account minus the interest rates on your mortgage, loan and credit cards.

It is a term that refers to the aggregation of interest on a saving over time. Put simply, gains beget gains. For example, if you earn 10% interest on £10 at the end of the year you’ll have £11. A year later, another 10% interest will leave you with £2.10. so even though the rate of interest remains the same, the nominal amount of interest that you’re earning is increasing over the years. It works the same way with returns. What it means in practice is that the longer you have to make the most of compounding interest or returns, the better, so investing a smaller amount earlier can work out better in the long-run than waiting to invest a larger amount at a later date.

It may be more helpful to think of it as interest accumulation.

5.ISA cash transfer
It is not transferring money from one cash ISA to another cash ISA.

It is transferring money from one stocks and shares ISA to another stocks and shares ISA. If, say, over the past two years you created two different stocks and shares ISAs with two different providers. You may want to simplify your accounting procedure by consolidating these ISAs under a single ‘roof’ (such as a fund supermarket). If the ‘roof’ that you select offers the same investment products as your current providers then you can avoid having to withdraw your assets from your current ISAs and can instead simply complete an ‘in-species transfer’—transferring your assets and holdings from one (or several) providers to another. If your chosen new provider does not offer the same investments then you complete a an ISA cash transfer, effectively transferring your money but having to change your underlying holdings.

The term assets transfer might cause less confusion.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Morningstar.co.uk Editors  analyse and report on shares, funds, market developments and good investing practice for individual investors and their advisers in the UK.