Top 10 things you need to know about holding cash versus investing

1) Risk

If you’re cautiously inclined, you may prefer the idea of holding your money in a bank or building society savings account instead of putting it into the stock market. It’s a matter of risk. If you hold cash, your capital is as safe as the bank it’s held in, whereas if you use your money to buy shares or funds, its value will fluctuate according to the fortunes of those companies and the wider market.

So, there’s no investment risk attached to a savings account, whereas you have to accept the likelihood of short-term volatility with an investment. However, there are other risks to be aware of when you opt for cash, as I’ll explain below.

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2) Return

The trade-off for taking risk with your money in the stock market is that it can potentially earn you a higher return.

According to the 2024 Barclays Equity Gilt study, UK stocks have on average returned 3.1% a year in real (inflation-adjusted) terms over 20 years, while cash lost -1.8%.

So, one danger if you settle for cash is that you miss out on potential higher returns you could have made by investing it – this is known as opportunity risk.

3) Timescale

However, the cash versus investment debate is not that simple. One key consideration is your time frame. Because volatility is an integral part of investing, there are bound to be times when the market falls and your holdings don’t look too healthy - and if that happens shortly before you need the money, you might find that your initial investment has fallen in value and not had time to recover when you come to cash it in.

The general view is that if you’re going to invest in shares, you should assume you’ll be tying your money up in the market for at least five years, and ideally longer than that. If you don’t have that length of time at your disposal, you might prefer cash.

4) Short-term needs

As well as lack of time to invest with confidence, there are other reasons why cash can make sense.

If you have an unexpected crisis – say you lose your job, or the boiler blows up – you need a cash cushion to fall back on. Investments don’t work well in this situation, because of the danger that you could lose capital if you have to sell at short notice.

In fact, even fixed-term cash bonds are not ideal, because they may not allow early access – and, even if they do, there will be penalties in terms of fees or reduced interest.

So, the first port of call in sorting out your finances is to build up a pot of easily accessible cash for emergencies or unanticipated expenses. Financial advisers will typically suggest you hold the equivalent of three to six months’ income.

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5) Buying the dips

Even if you’re buying into the stock markets, you may want to hold some cash as part of your investment strategy.

For example, if you have cash readily available and are brave enough to take a contrarian approach by buying unloved shares, you can use it tactically to top up your portfolio when the market – or a particular stock or fund you like – has had a setback.

If you invest in investment trusts, you can keep an eye open for trusts trading at a wider than usual discount to their net asset value (or popular trusts normally on a premium that have slipped into discount territory).

6) Smoothing the volatility

Alternatively, you might want to reduce the risk of putting all your eggs into a single basket that then smashes as the market falls, by ‘drip feeding’ a lump sum into your chosen investment over time.

The advantage of regular investing – perhaps monthly - is that you end up paying the average share price for your investment over a specific period, rather than paying over the odds. In a volatile market, you may end up with more shares at the end, because your money goes further in the months when the market is down.

If you put a cash lump sum into your interactive investor account, it’s possible to use it to fund a regular investment account rather than putting the whole thing into the market at once. You can find out more about free regular investing at ii by clicking here.

7)  The danger of inflation

Against all these situations where cash can prove its value, it’s important to remember that high inflation is disastrous for cash savers, because it rapidly erodes the amount your money will actually buy in the shops, at the petrol pump or online.

It’s therefore important, if you can afford to, to hold other assets that work well in an inflationary environment, such as commodities or shares that tend to do well when prices are rising, such as food or energy stocks.

Conversely, cash is a good thing to hold when deflation (reduction of prices) or disinflation (reduction in the rate of inflation) is happening, because it will gain buying power as prices fall.

8) Retirement and investment

The introduction of pension freedoms in 2015 has given pension savers greater flexibility to keep their pension invested and draw an income directly from the investment.

That investment needs to be carefully managed to provide a sustainable income for 30 years or more. And that is almost bound to involve taking some risk, with the pension fund at least partly invested in the stock market indefinitely (even if in slightly different holdings from earlier, when the entire focus was on growth).

The shift away from annuities and towards a self-managed (or adviser-managed) income-generating portfolio has radically changed the investment landscape, but one consequence is that older people are markedly less likely than they were to focus on cash and government bonds as the risk-free mainstay of their wealth. 

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9)  Pension protection

However, cash plays a very important role for retirees in so-called income drawdown. Again, it’s about the impact of short-term market movements.

If you have started drawing a regular income from your pension fund and continue to take the same amount of money out when the market takes a nosedive, you’ll have to withdraw more units from your fund to maintain your income, because units have fallen in value.

This is known as ‘pound cost ravaging’, and in the early years of retirement it can seriously undermine the fund’s ability to recover its value and provide sufficient income throughout future decades. 

Wealth managers therefore advise those in income drawdown to keep sufficient cash – two years’ worth if possible – to see them through a bear market (stock market declines of at least 20%), so that they avoid crystallising the losses in their pension fund by taking money out, and it can remain fully invested throughout the market recovery that will in due course follow the fall.

10) Compensation

Finally, if you’re seriously risk-averse and do want to stick with large amounts of cash, it’s worth remembering that there’s protection in place. If your bank fails – and that’s a rare event – your money is protected up to the value of £85,000 (£170,000 for joint accounts) by the Financial Services Compensation Scheme (FSCS).

It therefore makes sense to spread accounts worth more than that among two or more banks to ensure you’re fully covered. Cash held in a self-invested personal pension (SIPP) or trading account is also covered, although if the broker happens to use the same bank as you and it fails, that cash will count towards your £85,000 limit.

Investments get the same level of protection if your provider goes out of business and you are out of pocket as a result, but do check beforehand that the business is Financial Conduct Authority (FCA) or Prudential Regulation Authority (PRA) authorised, and that the activity it is carrying out for you is a regulated activity and FSCS-protected. And be warned, this does not cover poor investment performance. You can find out more on the FSCS website.