Interactive Investor

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

26th November 2021 13:44

by Faith Glasgow from interactive investor

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Deciding whether to tuck your money away in a savings account or invest in the stock market is not always straightforward. Here, Faith Glasgow discusses the various merits of each approach and important facts to consider.

Hoard or invest 600

1) Risk

If you’re cautiously inclined, you may well prefer the idea of holding your money in a bank or building society savings account to 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 is 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 we’ll see below.

2) Return

The trade-off for taking risk with your money in the stock market, of course, is that it can potentially earn you a higher return. Over the past 50 years, according to the Barclays Equity Gilt Study, cash has returned on average 2% a year, while shares have returned 5.7%.

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That extra few per cent may not seem a terribly big deal, but over the long term they make a massive difference. The study shows that if you had put £1,000 into a cash account 50 years ago, it would now be worth £2,692. But if you’d put it into the stock market it would have risen more than 15-fold, to £15,752.

The past decade of quantitative easing and ultra-low interest rates, introduced to get the global economy back on its feet after the financial crisis in 2008, has meant savings rates have dwindled well below that 2% long-term average. Even if you’re prepared to tie up your money for five years, you’ll only earn around 2% a year in interest, but many high street banks are paying as little as 0.01%, according to Anna Bowes of Savings Champion.

One danger if you settle for cash is, therefore, that you miss out on potential higher returns you could have made by investing it – 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.

To put that into context, since its launch in 1984, the FTSE 100 index – 100 of the largest companies listed on the London Stock Exchange - suffered four bear markets before the Covid crash of 2020. According to Refinitiv data, the average time for the index to recover to its pre-bear high across those four occasions was 1,765 days (just under five years), though that average masks wide disparities between the different occasions.

The general view is that if you’re going to invest in equities, 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.

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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 accessed cash for emergencies or unanticipated expenses. Financial advisers will typically suggest you hold the equivalent of three to six months’ income.

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 holdings, 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). Keep an eye open for interactive investor’s regular Bargain Hunter round-ups of interesting trust opportunities.

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 investment – 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.

The Bank of England targets an inflation rate of 2%, but the latest figures show consumer price index (CPI) inflation of 4.2% over the year to October, higher than the market expectations (according to a Reuters poll of economists) of 3.9%.

It is therefore important, if you can afford to, to hold other assets that work well in an inflationary environment, such as commodities or equities 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 or disinflation is happening, because it will gain buying power as prices fall.

8) Retirement and investment

Historically, most people without final salary-type pensions bought annuities that would pay them an income through retirement. The clever thing to do with your investment portfolio - particularly pension holdings – in the years approaching your planned retirement was progressively to ‘de-risk’ it, reducing the proportion of equities and increasing cash and fixed interest holdings.

The aim in doing so was to avoid being hit by market plunges, and to gradually align your portfolio with the gilt market (which shapes annuity rates).

But the introduction of pension freedoms in 2015 has changed all that, allowing people to keep their pension invested and draw an income directly from the investment. That investment therefore needs to be carefully managed so as 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.

A happy retiree

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 will 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 through 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, so that they avoid crystallising the losses in their pension fund by taking money out, and it can remain fully invested through 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 is protection in place. If your bank fails – and that’s a rare event – your money is protected up to the value of £85,000 (£170,00 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, though 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 FCA or 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.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

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