4 Mins
This is a question we are being asked by clients at present due to the volatility in investment values and the rise in interest rates. The landscape of returns from cash savings has changed dramatically over the course of the last 18 months. However, it is important to consider your longer-term goals for your money rather than be swayed by shorter-term returns from cash savings.
In this article, we delve into the factors to consider when determining whether cash is the best place for your long-term investments.
Cash is not inflation-proof
While cash offers certainty in its nominal value, it lacks protection against inflation’s erosive impact on its purchasing power. During periods of high inflation, cash rapidly loses its real value, making it inadequate for providing protection against inflation. Over the past two decades, cash has managed to outperform inflation and retain its purchasing power in only a few isolated years. Even during the era of low inflation before the COVID pandemic, deposit rates were languishing at historically low levels. Though current cash rates have surged, they still fall short of prevailing higher inflation rates, reducing cash’s real value protection.
Diversified portfolios for long-term investors
For investors with long-term goals, holding a diversified investment will likely prove a better option. Using an example of a portfolio consisting of 60% in equities and 40% in bonds, it may offer greater potential for generating real returns.
When comparing cash to equities and bonds across different time horizons, we find that cash savings have delivered negative real returns over the past 3, 5, 10, and 20 years, diminishing depositors’ purchasing power. While cash managed to retain a level of real value over a 50-year period, which will incorporate many different economic cycles, it is still lower than the returns generated by the equities and bonds portfolio. On the other hand, a balanced portfolio of equities and bonds has consistently outpaced inflation across timeframes of 5 to 50 years, irrespective of prevailing macroeconomic conditions.
This is illustrated in the chart below:
Source: Brooks MacDonald 2023
Hidden costs of fixed-term deposits
Higher returns on fixed-term deposits can be alluring, but investors must consider the reinvestment risk they may face when their original fixed-term investment matures. Reinvesting at potentially lower rates or looking to move back into investments carries the risk of missing attractive entry points into investment markets. This is particularly relevant if an individual decided to sell an investment to place the money in cash and re-invest again at a later date.
Historical analysis reveals that high deposit rates seldom persist over an extended period, with central banks often reducing rates after a peak. For example, in previous Bank of England base rate rises, there was typically a period of nine months from the date of the last interest rate rise and the first cut in interest rates.
Overall, locking into fixed-term deposits might sacrifice long-term opportunities for short-term ‘guaranteed’ gains.
Taxation
With interest rates rising, it is important to be aware of the impact of tax on the interest that you receive. Tax is not deducted directly from savings interest and you will need to ensure the correct amount of tax is paid on your interest with HMRC.
The Personal Savings Allowance allows up to £1,000 of interest to be earned tax-free by basic rate taxpayers and below. Whilst Higher rate taxpayers can earn £500 of interest tax-free per tax year. Additional Rate taxpayers do not receive a Personal Savings Allowance.
There can be a further allowance for some, called the “starting rate for savings”, whose earned income and other non-savings/non-dividend income is below £17,570 for the 2023/24 tax year. This allows up to £5,000 of interest to be earned without paying tax on it.
Taxation will therefore have an impact on the overall return that you receive from your cash savings and it is important to be aware of this and ensure your money is held tax-efficiently by using your ISA allowance where possible.
Conclusion
While cash may seem enticing in the current market environment, it is crucial to evaluate its role in your finances and overall objectives for your money both in the short term and long term. Investors should consider inflation, investment horizon, and reinvestment risks before prioritising cash holdings. For those seeking to preserve and grow wealth over the long term, a well-diversified investment portfolio comprising equities and bonds may offer better potential for generating real returns.
At Henderson Loggie Financial Planning we always recommend holding a sufficient amount in cash savings for shorter needs and emergencies. Overall, maintaining a balance between cash savings and investments is likely the best structure for your finances.
So whilst we do not recommend selling investments to hold in cash at present, we do recommend that you review your cash savings due to the recent interest rate rises. It is important to ensure that you are receiving the best rates of interest on your savings for your needs. We can help and advise you on this and can recommend suitable accounts for you.
In addition, it’s important that you diversify your cash savings to ensure that you remain within the Financial Services Compensation Scheme protection of £85,000 per banking institution.
As ever, we are committed to helping you make informed investment decisions that align with your financial goals. If you have any questions or would like to discuss your finances further, please don’t hesitate to contact us.
Best regards,
Jonathan McDowall
Henderson Loggie Financial Planning Ltd is authorised and regulated by the Financial Conduct Authority.
Past performance is not indicative of future results and no representation is made that results where stated, will be replicated. Investment values rise and fall and the value of them is not guaranteed. On encashment, you may not get back the amount invested.