Cash is paying 5% again, so why bother investing?

For much of the past decade, holding large amounts of cash was an uncomfortable experience. Interest rates were close to zero, savings accounts paid very little, and inflation steadily eroded the real value of money sitting in the bank. Investors were repeatedly reminded that, over the long term, cash was unlikely to generate the returns needed to preserve or grow wealth.

That argument has become rather less straightforward.

Following the rise in interest rates over recent years, savers have once again been able to earn attractive returns on cash deposits, money market funds and government backed savings products. For someone who can earn around 4% or 5% with relatively little risk, an obvious question arises:

Why take investment risk at all?

It is a perfectly reasonable question.

Why cash deserves a place in your portfolio again

For many years, cash was treated largely as somewhere to temporarily park money. Today, it deserves more serious consideration within a portfolio. For investors approaching retirement, people expecting a large expenditure or anyone uncomfortable with market volatility, receiving a meaningful return without taking significant investment risk can be very attractive. Cash can also provide something financial markets cannot – certainty.

If you know you will need £100,000 in eighteen months, for example, exposing that money to equity-market fluctuations may be entirely inappropriate. There is therefore nothing inherently wrong with holding cash. The question is how much.

Is a 5% savings rate as good as it looks after inflation and tax?

A savings rate of 5% sounds extremely attractive, but the number needs to be considered in context. The first issue is inflation. If inflation is running at 3%, a 5% return provides a real return of approximately 2% before tax. That is certainly better than the situation savers endured for much of the 2010s, but it is not necessarily enough to grow purchasing power significantly over several decades.

Tax can also make a substantial difference. Interest earned outside tax-efficient wrappers may be taxable once an individual’s Personal Savings Allowance has been used. For investors with substantial cash balances, the effective return can therefore be considerably lower than the advertised interest rate.

What is reinvestment risk when savings rates fall?

There is another important issue: reinvestment risk.

A saver might currently be receiving 4% or 5%, but there is no guarantee that those rates will still be available in three, five or ten years. If inflation continues to moderate and central banks reduce interest rates, savings rates are likely to follow. This creates an interesting dilemma.

Many investors moved into cash precisely because interest rates became attractive. They may eventually find themselves wanting to move back into investments after interest rates have fallen, potentially when equity and bond markets have already risen, so trying to move between cash and investments at exactly the right moment is extremely difficult.

Why long-term investing still matters when cash pays well

The case for investing has never really been that investments offer certainty. They do not. Shares can fall sharply, bonds can lose value, and even diversified portfolios will periodically experience uncomfortable periods. The reason investors accept this uncertainty is that productive assets have historically offered the potential for long-term capital growth. Owning shares ultimately means owning part of businesses that can grow their revenues, profits and dividends and over long periods, that growth can be extremely valuable. Cash, by contrast, does not grow economically. It simply receives whatever interest rate a bank or government is prepared to pay. For money that may not be needed for ten, twenty or thirty years, that distinction matters.

The problem with waiting for the perfect time

Some investors currently holding large cash balances are waiting for a more attractive moment to invest. Perhaps markets look expensive, or geopolitical risks appear unusually high. Maybe they expect a recession. There will almost always be a convincing reason not to invest. Unfortunately, markets have a habit of moving before the outlook feels comfortable. By the time the economic news improves, investment markets may already have anticipated the recovery. This is why attempting to perfectly time entry into and out of markets is notoriously difficult.

How much cash should you hold?

None of this means investors should minimise cash. Quite the opposite. A sensible financial plan will often include several different pools of money serving different purposes. An emergency fund may appropriately remain in cash. Money required during the next few years may also belong in low-risk investments or deposits. Longer-term capital can then potentially be invested with a greater ability to tolerate short-term fluctuations. This approach can be particularly useful in retirement, where keeping several years of planned expenditure outside volatile assets may reduce the risk of being forced to sell investments following a market fall.

The answer does not have to be cash or investments

Perhaps the biggest mistake is viewing this as a binary choice. Investors do not necessarily need to decide between holding everything in cash or investing everything in financial markets. For many people, the most sensible solution will involve both. Attractive cash rates have undoubtedly changed the investment landscape, and investors should make use of them where appropriate. But today’s interest rate should not obscure the reason long-term investing exists in the first place. Someone with a thirty-year investment horizon has a very different requirement from someone buying a house next year.

Good financial planning starts by separating those objectives.

At findawealthmanager.com, we regularly speak to people who have accumulated significant cash balances but are uncertain how much should remain secure and how much might appropriately be invested. A wealth manager or financial planner can help determine the level of investment risk appropriate for each part of your wealth. The challenge today is no longer simply deciding whether cash is attractive. It will be finding the right balance.