Is cash really king?

The relentless effect of inflation over time can be detrimental for those keeping large sums in cash and attracting interest at a low or even zero rate.

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  1. Rob Morgan

There is a saying in the investment world: Cash is king! Without cash, purchases can’t be made, debts cannot be settled, and dividends cannot be paid to shareholders. In this respect, cash is indeed king, and it always will be.

Yet in other respects, cash’s crown has slipped. With interest rates collapsing in the aftermath of the financial crisis and staying at ultra-low levels for over a decade, returns on bank and building society accounts are negligible. Adding to savers’ woes, the National Savings and Investments (NS&I) slashed interest rates on its products in November and will also be cutting the Premium Bonds prize fund.

Yet cash has been a poor home for people’s money for a long time now because its value has been steadily eroded by inflation. As the chart below demonstrates, cash has produced a very modest positive return over the last 10 years but, against inflation – rises in the cast of living – cash has failed to keep up. People’s spending power has gone backwards.

Chart: £100 indexed according to UK Consumer Price Index Inflation (blue) and return on short-term cash deposits (red) over the past decade.

Chart showing £100 indexed according to UK CPI

Source: FE Analytics, 31/10/2010 to 31/10/2020

Having cash reserves is important. Most people need a “rainy day” fund to cover unforeseen events – say 3 to 6 months income. For the purpose of saving towards shorter term goals, cash is appropriate too because it has the significant advantage of offering security of capital. Some investors also like to hold some cash to take advantage of opportunities in the market as they arise. Yet as the above chart shows, holding too much cash for long periods can be costly. Inflation can gradually eat away at the spending power. While the current annual rate of inflation at less than 1% may seem like a small number, the relentless cumulative effect over time can be detrimental for those keeping large sums in cash and attracting interest at a lower rate.

For instance, each £1 you spent in the year 2000, you would need to spend £1.70 today. Earning a competitive rate of interest on cash will certainly help, but it is difficult to earn an inflation-beating amount, especially in the current environment of low interest rates. Therefore, by keeping too much in cash investors could be at risk of not making the most of their money – or not achieving their long-term financial objectives.

Setting goals

It's important to set goals for different ‘pots’ of money and consider whether they are short term or long term in nature. Shorter term needs are generally considered to be less than five years, perhaps putting money aside for a new car or for a house deposit for example. Longer term goals include getting ready for retirement or making provision for school or education fees likely to be incurred in ten or more years’ time.

Short term needs are best addressed through saving cash and long-term ones through investing. Unlike cash, riskier assets do not offer security of capital, but over the long term they tend to do better and therefore they build wealth more effectively. Striking the right balance between risk and reward is something every investor must consider and revisit periodically – it’s important that to make the most of money, but it’s also vital not to lose sleep over it. It means having a financial plan and regularly reviewing it to check it is on track, as well as taking on the appropriate level of risk.

The future for cash

Sadly, keeping lots of cash could be becoming even more toxic. In the past decade, we have experienced quite low inflation, certainly by historical standards. Yet, there could be reason to suspect it will pick up – and it’s all to do with Covid-19.

To stave off economic crisis during the pandemic the world’s Central Banks, led by the US Federal Reserve and the European Central Bank, have created vast amounts of money. Rather than being used to plug a hole in bank balance sheets (as similar measures did in the 2007/08 financial crisis), this money is aimed at propping up businesses and individuals while the worst of the pandemic passes. It is therefore making its way to governments, and much of it into the pockets of ordinary citizens and is more likely to result in too much money chasing too few goods – a recipe for inflation.

At the same time, Central Banks will likely prioritise full economic recovery over controlling inflation. If so, that’s bad news for cash savers. Unless interest rates rise significantly, a jump in inflation is likely to put a significant dent in the spending power of cash in the bank or building society. The good news is a well-diversified investment portfolio can help preserve and grow a nest egg amidst the ravages of inflation.

Long term alternatives

Unlike cash, riskier assets do not offer security of capital, but over the long term they tend to do better than cash in providing a return above the rise in the cost of living, and therefore they build your wealth more effectively. Although it can be daunting to make the switch from saving cash to investing it, it can be beneficial in the long run. Once you have a good cushion of cash savings, it may make sense to invest any surplus.

Shares are more likely to outperform cash the longer you invest. Company earnings have the potential to grow faster than inflation over the long term, and this can drive both share prices and dividend payments higher, though unlike cash the value of investments and income can fall as well as rise so you could get back less than you invest. That’s why investing is only for those prepared to commit for the longer term – five years as a minimum – in order to have a better chance of riding out market ups and downs.

Cash has a place in everyone’s financial plan, that is not in doubt. But it should form part of that plan, not dominate it. There are alternatives, and some of them are not as risky as you may think – so long as you’re prepared to think long-term. For instance,  multi-asset funds offer a diverse portfolio in one convenient investment and aim to beat inflation by various amounts according to the amount of risk you are willing to take – however all investments can fall as well as rise, especially over the shorter term.

 

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This information does not constitute advice or a personal recommendation and you are recommended to seek advice concerning suitability from your investment adviser. The value of investments can fall as well as rise. Investors may get back less than invested. Past performance is not a reliable guide to future returns. Charles Stanley & Co. Limited is authorised and regulated by the Financial Conduct Authority.

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Investment involves risk. You may get back less than invested.