The right shares for your isa

However, history shows that recessions are often a good time to buy shares. UK stock market valuations are now cheap by past standards. If you can afford to take a medium- to long-term view, there is a strong case for loading up on high-quality shares while they're at current levels or lower.

The tax attractions

First, though, it's worth reminding ourselves of the tax attractions of investing via a self-select Isa, as these could well shape your choice of investment. You pay no further income tax on any earnings generated in your Isa, but if you hold shares or equity-based funds in it, the dividends paid by the underlying companies are paid net of tax at the basic rate of 10 per cent.

Basic-rate taxpayers therefore enjoy no income tax benefit from holding equities in an Isa, although higher-rate taxpayers still win because they don't have to pay the additional 22.5 per cent that would be payable on dividends outside the tax wrapper.

This tax issue underpins the argument of David Battersby, a portfolio manager at stockbroker Redmayne Bentley, that bonds are the best bet for Isas. "Unlike share dividends, the interest received on bonds and gilts is paid gross within an Isa so, particularly if you're investing for income, it makes sense to use the tax wrapper for the fixed-interest element of your portfolio," he says.

Capital gains are also fully protected from tax within your wrapper. As Jason Inglis of NatWest Stockbrokers points out, protection from capital gains tax (CGT) is generally considered to be the main attraction of using an Isa for equities.

"Gains in the value of stocks and funds can mount up to large sums over the long term, but when they're sheltered in an Isa you don't have to worry about managing those gains," he says. However, the downside of the tax wrapper is that capital losses, which many people will have suffered in the past year, cannot be offset against future gains, as they can with investments held outside of Isas.

For many bargain hunters currently buying shares for their Isa, the main attraction, therefore, is that they can pick up very cheaply priced offerings and tuck them away for the long term, in the expectation that values will eventually recover strongly. That could mean substantial tax-free gains in due course – assuming, of course, that they are successful in identifying the recession's survivors and thrivers.

Bargain hunting

"It's a good time to look for good old-fashioned bargain stocks – fundamentally sound companies at cheap prices. Thanks to crashing markets, there are lots of them," comments Richard Beddard, investment website Interactive Investor's blogger. "The only sector that is best avoided is financials, particularly banks. It's tempting to think they must be bargains because the prices have dropped so far, but there's still just too much we don't know and can't quantify." He stresses that the recession could last some time: "When you do find good companies, be prepared to hold on to them for years, and buy a diversified portfolio to protect yourself from the inevitable blow-ups."

Mr Battersby, too, picks out "the old stalwarts" – drinks companies such as Diageo; defence, which he considers to have "too many political interests at stake" for spending to be cut; and drugs manufacturers, which continue to be driven by long-term demographics.

Overall, then, investors should look for secure, well-known firms with sound business models. But the basic problem for most companies is lack of financing. In an environment where banks are not supporting businesses as they used to, companies are increasingly standing or falling by their ability to manage their cash flow and fund their debts and activities from month to month.

Companies with large debts are more likely to be crippled by refinancing problems and to have to cut dividends to meet their loan repayments. David Battersby favours companies with a debt-to-equity ratio of less than 30 per cent if possible, and certainly no more than 40 per cent.

Dividend yields – despite the fact that they are not entirely tax-free in an Isa – have also become an important consideration in an environment where capital losses have become par for the course, as they can contribute to total returns even where share prices are falling. However, widespread dividend cuts are expected in the coming year, and investors should look at yield forecasts from independent analysts before committing themselves.

Collective investments

For Isa investors who do not want the challenge of stock-picking, and who are looking instead for diversified exposure to an entire market, (ETFs) are a cheap, efficient and easily accessible way forward.

ETFs are collective investments holding all the stocks in a particular index or 'basket' of assets, and therefore closely reflect the movements of those underlying holdings. They can be used to follow not only stock market indices in specific developed and emerging economies, but also regions, industrial sectors and commodities.

Unlike index tracking unit trusts, they trade on the stock exchange throughout the day, just like ordinary shares, so the price reflects very accurately the movements of the index it follows. ETFs are also cheap: apart from the cost of buying and selling through a broker, their annual management charges range from 0.75 per cent down to as little as 0.4 per cent.

"It would be quite feasible to build a very well diversified Isa portfolio just from ETFs," points out Stephen Barber, head of research at broker Selftrade.

Even if you are not tempted to expand your existing portfolio into new holdings, you could consider making use of this year's tax allowance to 'bed and Isa' some of your best non-Isa investments. This is a particularly valuable exercise for larger investors who have built up substantial non-Isa holdings over the decades and need to manage their capital gains.

It's simply a matter of selling and simultaneously buying back shares in the same company within the tax shelter of an Isa. Any gains on the sale can be offset against your annual CGT allowance. "That way, you crystallise some capital gains and retain your holding, without being out of the market for any length of time; and you also get rid of future capital gains tax concerns on it," says Mr Battersby.

Dealing costs

The cost of share dealing can make a considerable difference to the overall performance of your equity Isa. Costs can vary enormously, depending on whether or not you trade online and whether you are prepared to pay for professional advice, for example.

The execution-only services available from online brokers offer the lowest dealing fees, starting at under £10 per trade. Be warned, however, that it can be extremely difficult to make comparisons between providers. For instance, some charge a single flat fee for both phone and online trades; but others have separate fee structures for phone and online.

Frequent trading can bring unit costs down considerably. Predictably, every broker has its own definition of what constitutes frequent trading, and every one discounts on a different basis. Look out, too, for regular trading services, which offer cheap dealing and will suit investors who prefer to drip-feed their cash into their chosen shares every month, rather than attempting to time the market.

Keep an eye open also for additional charges beyond the headline dealing charge: quarterly admission fees, inactivity fees, dividend reinvestment fees and fees for Isa administration are some of the unexpected extras you may encounter.