Investing in a Stocks and Shares ISA can be very rewarding.
But things do not always turn out that way. Indeed, sometimes the value of an ISA may go down rather than up.
Here are three mistakes I’m keen to avoid in my ISA.
1. Too much of a good thing
Over the past five years, Nvidia stock has soared 2,769%.
That means that, if I had invested all of a £20k ISA in the chipmaker in November 2019, I would now have an ISA worth over £570,000.
Wow!
But while it is easy to look at a share with the benefit of hindsight, that is not a luxury open to any investor when making choices. It was not inevitable five years ago that Nvidia would perform as strongly as it has.
If I had put all of a £20k ISA into Nvidia stock five years ago and things had not turned out as well, I would have taken an unnecessary risk by not diversifying properly. Nvidia has soared but many other companies that looked promising five years ago have sunk in value.
2. Focusing too much on past performance
When making choices about how to invest an ISA, it is common to look at the past performance of shares. That might be when considering earnings as part of a price-to-earnings ratio for valuation purposes or it could be for dividend purposes.
I think that makes sense, as past performance can give an indication of how a business has performed. My preference is to invest in firms with proven business models.
However, past performance, although informative, is not a guide to what may happen in future. Forgetting this crucial point can be a costly mistake, for example when it leads to investing in a high-yield share only to see the dividend slashed, or cancelled altogether.
To put this into context, consider Vodafone (LSE: VOD). Back in its 2019-2020 financial year, the company was turning over close to €45bn annually and paying a dividend of 9c per share. Like now, it benefitted from a strong brand, huge customer base, and competitive position in a market that looks set to stay large.
Fast forward to today. Revenues have fallen around 18% and the dividend has been halved. The company has been selling off assets, meaning revenues are likely to remain lower than they once were.
In the past five years, the Vodafone share price has fallen 56% and the dividend per share has fallen by almost as much. Five years ago, a previous dividend cut, inconsistent business performance, and large debt pile could have alerted a forward-looking investor to some of the risks, in my opinion.
3. Ignoring dividend cover
A related mistake is to look at dividends without considering the source of dividends.
When choosing income shares for my ISA, I look at what I expect to happen to free cash flows in coming years and what that means for dividend cover.
Just because a business goes through a weak patch does not necessarily mean the dividend is in danger. Whether it is depends on how well covered it is. If existing free cash flows barely cover (or fail to cover) the cost of the dividend as it stands, it is a red flag for me as an investor.
This post was originally published on Motley Fool
