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07 Nov 2022
Cash is king? Yes, in the short-term
Liquidity is essential, but cash cannot match the long-term growth
potential of equities.
“Cash is king” has been a popular phrase since the global stock market crash of 1987. It was used then to proclaim the superiority of cash over other assets, due to its tendency to sustain its value while others fall. It remains popular today, particularly when we see market corrections or crashes.
Of course, as investors, we accept that volatility in the stock markets is inevitable and essential. If we hold only the least volatile assets, we’re unlikely to see the returns we desire. However, the phrase is still relevant when we consider the importance of having liquid assets, e.g. cash, money market instruments, and short-dated bonds.
The importance of liquidity
There are two main reasons why even the most experienced investors, with the highest appetite for risk, keep a portion of their wealth in cash.
1. Cash = peace of mind
It’s often advised that you should keep 3 to 6 months of living expenses in an emergency fund which can be used, if needed, to cover unexpected expenses. Having a cash buffer in the bank means that you would not have to liquidate your portfolio if an emergency hit at an inopportune moment, i.e. when markets are going through turbulent times.
2. Cash = opportunity
Having cash in the bank gives investors the option to invest at an opportunistic moment to maximise returns. Every investor’s goal is to buy low and sell high. With the knowledge that the financial markets move in cycles (meaning they go through phases of expansion, peak, contraction and bottom out), many investors are tempted to “time the market”, in other words, to buy a particular asset at depressed prices with the goal of capitalising on their growth in the future.
However, opportunity is elusive
To the disappointment of many, unfortunately, timing the market is notoriously difficult. Even the most experienced and knowledgeable fund managers, backed up by teams of analysts, find it hard to beat the market (though they may get lucky once in a while).
Research shows that doing nothing, staying invested, and riding the wave is, generally, a more profitable long-term strategy.
Plus, holding cash has downsides
While many people think of non-volatile assets as risk-free, there are three significant risks and downsides you should consider.
1. Risk of institutional failure
If a bank or financial institution you hold cash with fails, the FSCS (Financial Services Compensation Scheme) only protects you up to £85,000 across all the accounts you might have with that institution.
2. Low growth potential
Over the past 10 years, interest rates have been extremely low. In countries such as Switzerland and Denmark, we’ve even seen negative interest rates (-0.75% and -0.60% respectively, while in the UK, the Bank of England has recently increased the cash rate for deposits to 2.25%. Though interest rates are currently rising, it’s uncertain when the Bank of England will decide that it’s time for a reversal.
3. Inflation risk
Today, the annual rate of inflation sits in the double digits at 10.1%, the highest level in 40 years. With inflation at 10% and interest rates at 2.25%, cash investors would naturally lose 7.75% in real terms, meaning their purchasing power is rapidly diminishing.
In summary, while it’s important to have cash for emergency situations and to create a general feeling of security, over the long term, cash investments tend to underperform equities. Cash is only king under very specific circumstances.
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The information contained in this article does not constitute a personal recommendation and the investment or investment services referred to may not be suitable for all investors. Any opinion or estimate expressed in this publication is Investec Wealth & Investment’s current opinion as of the date of this article and is subject to change without notice. The value of investments and any income from them is not guaranteed and may go down as well as up; you may get back less than the amount invested. Past performance is not an indication of future performance.