In recent months I have studied our obsession with cash, and the apparent blindness to the destruction of its value in real terms.
On one hand we are told that cash offers the lowest level of ‘risk’ and yet on the other hand we are being told that any ‘returns’ are effectively being decimated by continued low interest rates.
Picking up on the last point I searched for the best rate and found one plan offering 2.8% p.a. return if you were prepared to lock your assets away for five years. Inflation is expected to be around 3% p.a. over the next 5 years (according to M&G). This means that in real terms investors are losing 0.2% p.a. on their cash assets.
Financial planning is about challenging convention; this is not about taking risky bets but challenging the norm. Just because we have always done it, it doesn’t make it right. A senior economic analyst recently said that cash is fine for the short term (say 6 to 12 months) but any more and savers should be looking to invest in the market.
When cash was alive and well circumstances were different. Now a number of underlying factors have changed. Firstly if we retire at 65 we don’t expect to live 5 years, more likely we will live for 20 plus years. Secondly interest rates have been low for a number of years and will remain low for some time to come; saving rates are not going up any time soon and thirdly inflation will kill returns, a mathematician doesn’t need to tell us that at 3% inflation, cash returns are effectively negative in many cases.
In this blog I want to explore the subject that no-one wants to talk about and start a debate. Whether you agree with me or not, you may come away from this blog and consider that cash is dead (or you may not).
We habitually like cash for three reasons:
- Protection of capital – if I have £100,000, and I put it in the stock market it can go up and down and therefore there appears to be no protection of capital. With £100,000 in the bank I will always have £100,000.
- Liquidity – if I want to access the capital I can get it at any time and I don’t need to worry about timing the market, the capital is the same whatever the markets are doing.
- Guaranteed growth – if my account is paying 2%, I will get 2% again irrespective of what the market is doing.
If I ended my blog at this point, we would probably all agree this is a strong reason to hold cash. However, my argument is that this is what we have thought in the past and are attuned to think for the future and herein lays the problem.
Should we be worried about holding cash?
Short term (i.e. 6 to 12 months) no…….
Long term (i.e. 12 months plus) yes……
A recent report by Barclays described cash as a value destroyer.
If we focus on the past……..
In 1990 the FTSE All Share Index was down 9.72%, cash was up 14.89%.
In 1994 the FTSE All Share Index was down 5.85% and cash was up 5.55%.
In 2000 the FTSE All Share index was down 5.90% and cash was up 6.17%.
So the past tells a story, in periods where equities are performing badly cash holds firm. This was true in 2008 where equities were down 29.93% and cash was up 5.52%.
But for the last five years cash has returned around 1% p.a.
You can get higher rates on cash if you are prepared to lock it away, but then you take away the liquidity because you cannot access your funds without some form of penalty. If you are prepared to lock money away for 5 years to get a poor return then surely equities hold the potential for better returns over that period?
Cash as a value destroyer
The figures don’t tell a lie.
If liquidity on cash is important then the types of rates in an ISA we might secure are around 2% (if we are lucky). M&G have indicated that inflation over the next 5 years will be around 3%. This means in real term the capital is declining by 1% p.a.
An investment of £100,000, with 2% increase per annum, will be worth around £90,000 in real terms in five years’ time. (This does not mean that the balance is reduced by £10,000, but that the equivalent ‘buying power’ of this money is effectively reduced because prices have increased)
If the investor wants any type of income and takes the 2% then the value would fall further because effectively there is no growth on the asset and its real value drops to around £73,000.
What about income from cash?
Income is a big issue, in the past where cash was yielding 6% plus it could provide a good income in retirement………this is no longer the case.
If you take the interest it is unlikely to be at a level that delivers the income that is needed. This means the investors get a double hit. Not only do they suffer from inflationary decreases but to deliver the income they have to eat into their capital.
The idea that the capital is safe is gone. So for example 2% interest and 5% income means that the capital is reducing by 3% p.a. without considering inflation.
Equally an income of 5% will have to increase to keep up with inflation.
In summary cash can no longer deliver sustainable returns and provide an income. It is only good for short term needs.
What about equities
JPMorgan recently presented a guide to markets and this showed some really interesting facts.
A 1% increase in interest rates will cause 10 year government gilts to fall 15%; this means the second tier of safety goes. Cash rates will not increase at the same level as interest rate rises.
Equities however are shown to be resilient in a rising interest rate environment. Interest rates are low because an economy is struggling and not growing or at best growing slowly, an increase in interest rates shows an economy is starting to grow and in that environment equities are proved to grow as well.
This means that equities could (for some time to come) deliver good long term returns especially when compared to cash and some fixed interest investments.
Equities can deliver income, and growth. A diversified portfolio can deliver this and keep the risk to the portfolio at a minimal level.
It’s a hard pill to swallow but for too long we have considered cash to be safe, if we don’t review our approach in this area it will destroy our retirement plans. There are reasons to hold cash but holding for the long term should no longer be one of those reasons.
So what do you think?