Many investors have cash as part of their portfolios. Cash is an appropriate holding for many reasons, but there is a tendency for many investors to be overinvested in cash, and sometimes significantly so. Why is that the case, and what are the pros and cons of being invested in cash? And, what should investors consider now, at a time when interest rates remain low?
One of the reasons why many investors have funds invested in cash is due to their low risk disposition. They are not comfortable with the potential risks associated with other investments. For some investors, investing in cash may be what they feel most comfortable with. However, they may not be aware of either the potential downsides to their wealth being invested in cash or the alternatives available to them.
Others invest in cash due to inertia. They worry about making the wrong investment decision, which results in doing nothing and remaining invested in cash. With so many decisions to make - such as what to invest in, what financial advisor to engage, who is the cheapest to invest with - one can be put off and end up, by default, remaining invested in cash.
Some investors may have no long term financial plan. They may have chosen not to engage a financial advisor who could assist in developing and implementing a plan suitable for their needs and objectives. They may be put off by costs attaching to investment products and the fees charged by financial advisors.
Undoubtedly there is a role for cash in an investment portfolio alongside other asset classes. It can be used to effectively lower the overall risk profile of a portfolio. It can also provide liquidity as required by the investor. A good example is in a post-retirement pension (i.e. Approved Retirement Fund) where it may make sense to hold an element in cash to meet short-term income distribution requirements. Doing this allows a more long-term investment strategy approach regarding the balance of the fund and thereby avoid encashments when market conditions are not favourable.
One of the most fundamental costs of investing in cash is inflation. Inflation erodes the purchasing power of money over time. Investors with large amounts of cash earn a return less than the rate of inflation, and will see the real value of their cash reduced over time.
Currently, financial markets are experiencing generally very low to negative nominal interest rates. Negative interest rates along with inflation will accelerate the erosion of the real value of an investor’s cash holdings.
Investing in cash also represents potential missed opportunities. What could an investor have benefited from if they had invested in other assets?
For example, if you invested in World Equities before the global financial crisis on 4 June 2007 and you held your investment until 23 March 2020, the lowest point for equity markets in 2020, your investment would have grown 61%. That’s an annualised return of 3.8%.
During that time, you would have experienced two of the largest economic and market shocks in history. In spite of that, the value of your investment still grew. If you had invested in cash (as measured by JPMorgan EMU Cash - 3 months) for the same period, your investment would have grown by 14.97% - an annual return of 1.10%.
Even though you had invested at the peak of the market in 2007, and disinvested at the lowest point during the COVID-19 pandemic, by investing in equities you still would have received a return greater than investing in cash.
If you are considering diversifying out of cash and into equities, is now a good time to do so? The long term trend of the equity market is positive, with returns for those prepared to invest for the long term, in excess of what would be available from investing in cash. Due to the volatility of markets, equities should be considered as a long term investment - for more than 10 years. If you are investing for periods of this duration and wish to increase the real value of your assets, investments such as equities will give you the best opportunity to achieve this.
Investment in equities should be considered as part of an overall financial plan. This should take into consideration your appetite for and comfort with equity risk. It should ensure that whatever equity exposure you decide upon is appropriate for you. This structured approach helps investors to avoid making decisions with a short term focus. This would include disinvesting after a period of negative market returns. Resisting the temptation to cash out when times are tough has proven on many occasions to be the correct move. Historically, markets recover over time. The mantra of investing in equities is, and remains, that it is all about time invested, not timing your investment.
Put time aside to take stock of what you have invested. Have a full picture of your investment assets, including pension benefits. Split them out across the main asset categories (equities, property, alternatives, sovereign/corporate bonds and cash) so that you get an overall sense of the risk profile of your invested wealth.
Consider what your main investment objectives are: short-term (children’s education, support children in property purchase, lifetime transfer of wealth) and medium/long-term (when plan to retire, income required in retirement, transfer of estate on death). Also consider what level of investment risk you are comfortable with, and what long-term return you are seeking on your invested wealth.
Having considered your assets and what your key financial objectives are, you should sit down with an adviser to discuss where you are and what you are planning to achieve. A good financial adviser should be able to sense-check your plan, prompt you to consider specific areas such as taxation planning, pension planning and investment strategy, and advise you on finalising and implementing your plan.
As economic events disrupt people’s wealth and financial plans and as pension and tax legislation evolves, it is important to take the best advice available and ensure you make the right decisions regarding your finances. Our team has the expertise and experience to help you as you face the future. Contact us today.