By Michelle McGrade, chief investment officer of online investment platform TD Direct Investing
‘Is cash king?’
The current very low interest rate environment means investors are getting minimal returns from cash. The real return on cash is just into negative territory; this is because inflation is rising and is eating into its value. The cost of holding cash is also becoming an issue – indeed some banks in Europe are passing this cost on to customers and UK banks are thinking they may be forced to do the same if interest rates go down any further.
But it’s the invisible threat to cash in the shape of inflation that is a concern – when prices start to reflect rising inflation, which is already happening, your cash won’t buy as much. What does this mean? Let’s say today you have £100 in a savings account that pays a 0.25% interest rate. After a year, you will have £100.25 in your account. That’s not much to celebrate, and as a double whammy, inflation is currently running at 1.0%, so the real value of your money is effectively £99.25.
Inflation has risen because the prices of food, air fares and petrol have risen. Because inflation is outpacing the interest rate, you have actually lost some purchasing power. If your savings don’t grow to reflect this rise in prices over time, in effect you will be losing money.
Despite this, there are some good reasons why you should hold at least some cash.
As well as keeping some aside for emergencies and liquidity, it is sensible for investors to have some allocation to cash within their portfolios. Alongside asset classes like government bonds and gold, cash is a ‘safe haven’ asset. These assets tend to hold their value during periods of market volatility as they generally have a low or negative correlation with equities. What makes cash unique among safe haven assets is that it holds its absolute value. In other words, its value stays steady though its relative value versus other asset classes and other currencies may fluctuate.
‘The dash from cash’
As illustrated above, cash produces almost no return/yield in an environment where the central banks are keeping interest rates low to stimulate economic growth. Central banks started this in the wake of the global financial crisis and we continue to see it today. The current rate paid to cash investors is very low compared with the yield paid to investors with riskier assets like equities. As and when central banks do start to raise interest rates, cash investments would be expected to see an increase in yield over time. The chart below shows cash, UK inflation and the Bank of England interest rate since 1989, when Libor was introduced as a measure of the value of cash.
When interest rates rise – and they will
In periods of rising interest rates, and rising inflation, cash performs well relative to other asset classes because it’s less sensitive to interest rate changes – also described as having short duration. Duration measures how much an asset’s price is expected to fall or rise when interest rates rise/fall.
How much should I allocate to cash?
When making cash allocation decisions, investors need to consider their investment objectives, time horizon and risk tolerance. An investor with a long-term investment horizon and high return objectives may want to hold only a relatively small cash position in their portfolio. For those with a shorter-term horizon more cash may be appropriate.
If you’re a young person planning to buy a house soon, you may want to hold all your assets in cash so you’re ready to deploy it when the right opportunity comes along. Even if you’re not looking to invest in a property, you are likely to want to set aside some cash for holidays or important purchases like a car. If you have children you may need access to money to pay for school or university fees. Think about what you may need to spend on and ensure you have access to enough cash to cover these costs.
What should I do with the rest?
The short answer is invest it. At TD Direct Investing, we take the view that investors should use cash as part of an active asset allocation decision within their portfolios depending on their investment objectives.
Given the current uncertain backdrop where both equities and bonds are starting to look fully valued some investors are nervous about how to protect their capital. A good way of doing this could be via a defensive multi-asset fund. Such funds often have large cash allocations and typically lag behind their peers during stock market rallies, but are better placed to protect capital when markets undergo a downturn. It is therefore logical for investors to hold these types of funds so they can make gains, or at least not lose money, in both bull and bear markets.
There are a number of multi-asset funds in our Recommended Funds list which have a large allocation to cash. Funds you could look at include Investec Cautious Managed, Henderson Cautious Managed and Premier Multi-Asset Growth & Income.
Time, not timing
Markets don’t go up or down in straight lines and it’s always difficult to pick the right time to invest. Investors should not be using cash as a way of timing the market. Once you invest, stay invested to give you the best possible chance of growing your assets over time.
You can take some of the emotion out of the timing of investment decisions by using regular investing on your account, which will automatically drip feed your money into investments over a longer period, smoothing out the highs and lows of the market.