Cash versus investments – should I invest or keep my money in the bank?
Monday 24th May, 2021
If you keep your money in cash, you won't run the risk of losing it, but currently low interest rates almost guarantee terrible returns from savings accounts. If you invest your money into shares, bonds and property; the value will go up and down and you run the risk of getting back less than you put in. However, the returns over the longer term are likely to be substantially higher.
"Should I save or invest my money?" This conundrum faces many people looking for better returns.
So, which is better? Cash or investments?
In the next few paragraphs, I will explain what we mean by cash and investments and will also cover what the main risks of cash and investments are. Lastly, I will discuss performance and which provides a better return.
Investing into stocks and shares can often seem quite scary. If you listen to the radio on the way to work, you constantly hear how the markets are up or down. They have specialists on the news and economic programs who talk about market cycles, asset allocations and bull and bear markets. The public psyche has been bombarded with films like “Wall Street” and the “Wolf of Wallstreet” where greedy men get richer through the stock market and the blue-collar man in the street ends up losing everything.
As a result of this, many prospective clients I come across just want to put their money into a nice safe cash account and get their 0.1% return each year. The argument is, “At least I am not losing money.”
But those very same people, who have safely deposited their savings into a deposit account at their bank still quietly approach me at barbeques and ask me, “Should I be investing my cash?”
Something is telling them that they could and should be doing better.
So, which is better? Cash or investments.
In the next few paragraphs, I will explain what we mean by cash and investments. I will also cover what the main risks of each are. Lastly, I will discuss performance and which provides a better return.
What is cash?
Cash includes bank deposit accounts and money market instruments. They tend to be fairly low risk investments and therefore have a corresponding low rate of return. You are probably never going to lose all your capital on a cash investment even if the bank fails. There will normally be some kind of compensation scheme available that will ensure that you get some of your cash back.
If you hold money with a UK authorised bank, building society or credit union that fails, the Financial Services Compensation Scheme (FSCS) will automatically compensate you:
- up to £85,000 per eligible person, per bank, building society or credit union.
- up to £170,000 for joint accounts.
The easiest way to negate the risk of bank failure is to save across a wide range of different banks, thus ensuring that all your eggs aren’t in one basket. If one bank fails, then you will only lose a small proportion of your original capital.
Your biggest risk with cash deposits is that the post-tax return is seldom greater than the inflation rate. To demonstrate this, I looked at Money Supermarket this morning to get an idea of the best rates available. They were as follows:
- Easy access – 0.41% (variable) per annum
- 1-year bond – 0.79% (fixed) per annum
- 2-year bond – 0.96% (fixed) per annum
- 3-year bond – 1.06% (fixed) per annum
- 4-year bond – 1.1% (fixed) per annum
- 5-year bond – 1.35% (fixed) per annum
Now this was just a brief search and I am sure that there may be higher rates out there. However, none of the above offers were from high street banks, which means that the majority of savers are holding savings that are achieving even lower returns.
The Consumer Price Index (CPI) for April 2021, is at 1.5% (BBC News). This means that the cost of living is growing faster than the value of most saver’s deposited capital, which in turn means that the buying power of their original capital and the income it produces is falling all the time.
I often meet clients who say to me that they just cannot bear taking risk on investments. That is all very well and I do believe that it is important that you feel comfortable with where your money is held. However, many people don’t realise the full impact of inflation. I therefore illustrate it for them with the following scenario:
- You invest £100,000 into a 10-year fixed rate deposit account yielding 2% per year after tax (I am aware this is all completely unrealistic, but bear with me)
- Inflation is running at an average of 3% per year for that period
The negative impact this will have on the buying power of your funds is demonstrated in the table below:
As you can see from this table, the real buying power of your money will actually fall during the 10-year period by almost £9,500 (-9.5%) as inflation is increasing at 1% per annum more than the annual return on your investment. I accept that this is a fairly basic illustration, but it remains a true reflection of the unseen risk to cash investments. Your original capital may well be safe, but its buying power is spiralling down. The impact of this sort of value erosion is far more insidious in a way, because ostensibly the value of the money is going up all the time creating the false impression of growth. It creates an undue sense of security, and the effects creep up on the investor.
What do we mean by investing?
Whenever we talk about investing, we generally refer to putting your money into a diversified portfolio made up of:
- Corporate & Government Bonds
- Shares
- Commercial property
Corporate & Government Bonds
These are structures that allow you to lend money to companies or governments over a fixed period of time in return for a regular interest payment for the period of the loan. At the redemption date the original capital is paid back to the lender.
The biggest risk with these is the possibility that the borrowing company or government may default on the loan and fail to pay it back. The greater the risk of the company/government defaulting; the higher the yield the bond will pay. You are effectively getting paid danger money for investing with the risky company/ government.
A perfect example of this is when the Greek economy was at the edge of collapse during the financial crisis. Greek government 2-year bond yields rose to 15.3% following a downgrading by Standard and Poor’s. When compared with average rates at the time for other European countries of 4%, this high rate clearly reflects the dangerous level of risk the investor would be taking.
There is an erroneous view that Bonds are low risk. As we can see from the above paragraph, the level of risk is entirely down to the financial strength of the institution being invested in.
Aside from the coupon (interest paid), Corporate Bonds and Government Gilts can be bought and sold on an open market. The underlying value of the Bond or Gilt is generally corelated to the interest rate. When interest rates rise, the market value of the Bond or Gilt will fall, as the attractiveness of its fixed rate is reduced. As interest rates fall, the attractiveness of the fixed coupon increases and its market value will increase.
The market value of Bonds and Gilts is also dictated, to an extent, by the performance of equity markets. When shares are performing well, Bonds and Gilts are regarded as less attractive, due to their overall lower growth prospects. However, when equity markets enter a bear phase, we often experience a “flight to safety” where investors move away from shares to the perceived stability and predictable returns of Bonds and Gilts. The increased demand naturally results in the market value of the Bonds and Gilts increasing. This relationship between equity and bond markets in which one variable increases in value, as the other decreases in value; is known as negative or inverse correlation and forms the basis for diversification of asset classes within a portfolio to moderate volatility and risk.
Shares
A share is effectively where the investor buys a portion of a company. The value of the share will increase or fall in line with the financial performance of that company and the demand for the share on the open market.
The share carries with it certain rights for the investor such as the right to share in profits in the form of dividend payments, as well as the right to vote at annual general meetings.
Dividends are very important. Many investors look at a share in terms of the increase in its value on the open market, while forgetting about the benefit of the regular dividend that it pays out. However; the boost to growth provided by reinvested dividends is substantial and not to be sneezed at. Even if the underlying value of the share falls, the company may still provide a dividend. Some companies, known as dividend aristocrats, have provided a constantly rising dividend yield for 25 years or more.
The risk involved in investing in shares is once again down to the nature of the company whose shares you have purchased. Large well-established companies like General Electric or Vodafone will not provide stratospheric growth as they are nearing the limits of their overall growth capacity. However; their stability and high dividend yield paid from their regular profits make them attractive.
Smaller, newer companies either in the UK, US or developing countries offer far more growth potential as they are new ventures. However, as they are focussing all the profits towards growth, they are unlikely to offer dividends at all and they will likely be highly volatile as a result of their youth and drive for growth. They are very risky, but when the risk pays off the returns can be like winning the lottery.
Property
Now when we refer to property as an asset class, we are normally talking about commercial property. This includes office space and space in shopping malls. In the past many investors bought this asset class thinking that it was residential property. Many an investor signed on the line that is dotted to the battle cry of, “Go on. Everybody needs a place to live. What can go wrong?”
What can go wrong indeed! Commercial property is a very good asset class to use to diversify a portfolio, as it reacts differently to various market stimuli than other asset classes. When rentals are high and markets are booming commercial property offers a very good return, however when everything goes pear-shaped, which will inevitably happen, you cannot simply sell it and move to another asset class. As it is property, it becomes illiquid in a down market and virtually impossible to sell. Rentals fall as companies go out of business or can no longer afford the cost of expensive city office spaces. The only thing the investor can do is sit tight and hope for the market to turn quickly.
We have seen examples of this happening during the Covid 19 market crash, where commercial property started looking very unattractive, with so many people working from home. There was a run on the funds, but insufficient liquidity to pay the investors out. The fund managers therefore placed a moratorium on liquidations, with funds closed to further withdrawals. Investors found themselves suddenly stranded in funds, with no option to sell out. Something similar happened after the Brexit Referendum in 2016, and the FCA is now looking at restrictions on property funds,
which could require investors to give between 90 – 180 days’ notice before they can withdraw their money.
So how do you reduce the risk of the different asset classes?
Investment specialists have come to realise that the best thing to do when investing, is to spread your investments across a number of different asset classes, geographic regions and industries. This is known as diversification.
The reason for doing this is that the various assets classes respond to market conditions differently. As demonstrated in the diagram below, a bull market will generally result in shares being up and Bond and Gilts being down.
Similarly, certain industries may trend at different times. This was demonstrated brilliantly during the COVID-19 pandemic when certain tech stocks performed very credibly, as a result of the increased focus on virtual meetings and working from home. Just as different asset classes and industries may perform/underperform at different times, different countries and geographical regions will also respond either positively or negatively to the current political and economic climate prevailing at the time.
In reality it is just about impossible to guess with absolute accuracy, which assets, regions and industries are likely to perform best at any one time. However, you can make an educated guess at what is likely to happen. By firstly spreading your risk across a broad range of asset classes, regions and industries (strategic asset allocation), and then tweaking it in line with the areas you feel will perform well, you are able to moderate the risk and volatility of your portfolio. If your predictions are correct, then your portfolio will benefit from your favouring of those particular positions. However, if you are wrong, you still have exposure to the other areas, thus moderating the under-performance and either mitigating losses or capturing at least some gain.
It is however important to note that spreading your investment across different asset classes does not totally eliminate the possibility of loss. You can also have a diversified portfolio which is very concentrated in specific areas or asset classes. This is what you do when you have a high conviction that a specific asset class will do well. In this situation, the volatility and risk goes up, but so does the growth potential.
The news talked about billions being wiped off the stock market?
One of the biggest risks to your investment performance is actually you and how you react to your portfolio’s performance. Often my clients will hear a news broadcast, which talks about billions of pounds worth of value being wiped off the value of shares in a market correction. They are horrified and get on the phone to me very quickly.
Now the important thing to remember with investments, is that values will go up and down, but no loss is a reality until you actually sell the investment. The losses that the news broadcasters are talking about are only temporary losses and are not set in stone. The value of the shares may have come down, but the losses are what we call “paper losses”. Provided you don’t sell the shares, there is every likelihood that they will bounce back over time, the original value will be restored and growth will continue.
This brings me to a very important point. If you are investing in the stock markets, you are doing so because you believe that they will go up over the medium to longer term and they will perform better than cash. If this is not the case, there is no point in doing it. It is important to note that history tells us that over a 10-year period you will likely experience at least one period where markets fall 20%. During these periods the newspapers will be screaming about contraction of the economy, unemployment, businesses closing and years required for recovery. The temptation to pull out your investments at this point are huge. This is where many investors make their biggest mistake. They give in to temptation and sell at the bottom of the market, thus crystallising their losses. This cycle of buying at the top of the market and selling near the bottom is demonstrated below.
So which is better? Cash or investments?
The answer to the question is going to be like most answers in financial planning: It depends on what you are trying to achieve.
From a pure performance perspective, it helps to look at the graph below:
As we can see, over the short term, UK shares are volatile and you are really better off in cash deposits, which display a steady upward trend. However, as the investment term increases, the volatility of the investment starts to flatten out into a more consistent and noticeable upward trajectory and gradually pulls away from the cash savings in terms of returns. This holds true, even after it goes through periods of correction.
The answer to the question is therefore that cash is best for saving for short term goals, where stability of the principle is more important and it is crucial that you do not end up with less money than you started out with.
However, when saving for longer term goals such as retirement and children’s university fees or a dream holiday at a specific age, it becomes far more important that your money retains its value in real terms and achieves some growth. It therefore makes far more sense to put your money into asset backed investments that will allow you to achieve this.
Final thoughts
For many people, this may not be the answer they are looking for. You may be hoping for some magic bullet that will provide you with returns without risk. These may exist somewhere, but from experience, the cost always outweighs the benefit and there is always a catch.
If you are not comfortable with investing, but recognise the need for more growth on your savings, I think you should consider a middle ground. Hold some of your money in savings and hold some in investments. In reality, this is what most people should be aiming for.
If it all seems too confusing, then take some advice. It is most certainly better than doing nothing.