Education – the role of cash in a portfolio

'Is Cash King?'

The current very low interest rate environment means investors are getting minimal returns from cash. The real return on cash is actually just into negative territory; this is because inflation is rising and is eating into its value. The cost of holding cash is also becoming an issue – indeed some banks in Europe are already passing this cost on to customers and UK banks are thinking they may be forced to do the same if interest rates go down any further.

But it’s the invisible threat to cash in the shape of inflation that is a concern; when prices start to reflect rising inflation, which is already happening, your cash won’t buy as much. What does this mean? Let’s say that today you have £100 in a savings account that pays a 0.25% interest rate. After a year, you will have £100.25 in your account. That’s not much to celebrate, and as a double whammy inflation is currently running at 0.6%, so the real return on your money is actually £99.40. Inflation has risen because the prices of notably food, air fares and petrol have risen. Since you will only have £100.25 in your account, you have actually lost some purchasing power. If your savings don’t grow to reflect this rise in prices over time, in effect you will be losing money.

Despite this, there are some good reasons why you should hold at least some cash.

As well as keeping some aside for emergencies and liquidity, it makes sense for investors to have at least some allocation to cash within their portfolios. Alongside asset classes such as government bonds and gold, cash is a ‘safe haven’ asset. These assets tend to hold their value during periods of market volatility as they generally have a low or negative correlation with equities. What makes cash unique among safe haven assets is that it holds its absolute value. In other words its value stays steady though its relative value versus other asset classes and other currencies may fluctuate.

'The dash from cash'

As illustrated above, cash produces almost no return/yield in an environment where the central banks are keeping interest rates low in order to stimulate economic growth. Central banks started this in the wake of the global financial crisis and we continue to see it today. The current rate paid to cash investors is very low compared with the yield paid to investors from riskier assets such as equities. As and when central banks do start to raise interest rates, cash investments would be expected to see an increase in yield over time. The chart below shows cash, UK inflation and the Bank of England interest rate since 1989, when Libor was introduced as a measure of the value of cash.

Cash, inflation and interest rates since 1989

When interest rates rise – and they will

In periods of rising interest rates, and rising inflation, cash performs well relative to other asset classes because it’s less sensitive to interest rate changes – this is described as having short duration. Duration measures how much an asset’s price is expected to fall or rise when interest rates rise/fall.

How much should I allocate to cash?

When making cash allocation decisions investors need to consider their investment objectives, time horizon and risk tolerance. An investor with a long-term investment horizon and high return objectives may want to hold only a relatively small cash position in their portfolio. For those with a shorter-term horizon more cash may be appropriate.

If you’re a young person planning to buy a house soon, it could be that you want to hold all your assets in cash so you’re ready to deploy it when the right opportunity comes along. Even if you’re not looking to invest in a property, you are likely to want to set aside some cash for holidays or important purchases such as a car. If you have children you may need access to money to pay for school or university fees. Think about what you may need to spend on and ensure you have access to enough cash to cover these costs.

What should I do with the rest?

The short answer is invest it. At TD Direct Investing we take the view that investors should use cash as part of an active asset allocation decision within their portfolios depending on their investment objectives.

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Given the current uncertain backdrop where both equities and bonds are starting to look fully valued some investors are nervous about how to protect their capital. A good way of doing this could be via a defensive multi-asset fund. Such funds often have large cash allocations and typically lag behind their peers during stock market rallies, but are better placed to protect capital when markets undergo a downturn. It is therefore logical for investors to hold these types of funds so they can make gains, or at least not lose money, in both bull and bear markets.

There are a number of multi-asset funds in our Recommended Funds list which have a large allocation to cash. Funds you could look at include Investec Cautious Managed, Henderson Cautious Managed and Premier Multi-Asset Growth & Income.

Time, not timing

Markets don’t go up or down in straight lines and it’s always difficult to pick the right time to invest. Investors should not be using cash as a way of timing the market. Over the long term sensible investing should help you prosper. And once you invest – stay invested to give you the best possible chance of growing your assets over time.

You can take some of the emotion out of the timing of investment decisions by using regular investing on your account, which will automatically drip feed your money into investments over a longer period, smoothing out the highs and lows of the market.

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Investors should be aware that the value of investments can fall as well as rise, you may get back less than you invested. If you are unsure about the suitability of a particular investment you should speak to a suitably qualified financial adviser.