How much of your wealth should you hold in cash? Often viewed as the ‘safe’ option that is secure and reliable there is a real danger that holding too much cash will cost you a fortune in the long run as it’s value gets eroded away.
t’s easy to see why people choose to hold large sums in cash. As it’s something we handle every day, whether physically or digitally, it can seem more tangible than other assets. The Financial Services Compensation Scheme (FSCS) also protects up to £85,000 should a bank or building society fail per individual. The combination of these factors may mean you view cash as the most appropriate way to hold wealth.
However, cash does lose value and this is particularly true in the current low-interest climate.
Interest rates have been at a historic low for more than a decade following the 2008 financial crisis and The Bank of England has recently cut rates even further. In March, as it became apparent Covid-19 would have an economic impact, the central bank slashed the base interest rate to just 0.1%, the lowest level on record.
Whilst potentially good news for borrowers, the rate cut isn’t positive for savers. It means your savings aren’t going to deliver the returns they once were, especially if you compare the current rates to the pre-2008 ones. Before the financial crisis, you could expect to enjoy interest rates of around 5% but getting returns over 2% on cash is now a real achievement.
At first glance, whilst lower interest rates can feel frustrating many people don’t feel a need to change how they hold assets. After all, your money is secure and whilst it might not be growing very fast, it’s not going down, right? This is true if you’re just looking at the amount that’s in your account. However, in real terms, the purchasing power of your savings will be falling.
Inflation: Affecting the value of savings
Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.
Ronald Reagan
The reason the value of cash savings falls in real terms is inflation. Each year the cost of living rises and if interest rates fail to keep pace with this, your savings are gradually able to purchase less and less.
The Consumer Price Inflation (CPI), one of the measures for calculating inflation, for April 2020 suggests the inflation rate was 0.9%. This figure was down on long-term averages due to coronavirus restrictions, however, it’s still higher than the base interest rate. As a result, the spending power of cash savings will have fallen.
Year-to-year, the impact of inflation can seem relatively small. Yet, when you look at the impact over a longer period, it highlights the danger of holding too much in cash.
Let’s say you placed £30,000 in a savings account in 2000. Following almost two decades of average inflation of 2.8% a year, your savings in 2019 would need to be £50,876.75 to boast the same spending power. With low-interest rates for more than half of this period, it’s unlikely a typical savings account would help you bridge this gap.
When is cash right?
Whilst inflation does affect the spending power of cash savings, there are times when it’s appropriate.
If you need ready access to savings cash accounts are often suitable, for example, if you have an emergency fund. When you’re saving for short-term goals (those less than five years), a savings account should also be considered. Over short saving periods, inflation won’t have as much of an impact and can preserve your wealth for when you need it.
For some organisations, there is a legal and structural reason to hold cash. Charities are required by law to hold reserves and companies need to maintain emergency funds and meet liquidity requirements. We have patterned with Cascade Cash Management to provide solutions for such organisations and individuals and you can see the latest interest rates on our latest Interest Rate Bulletin:
However, when setting money aside for long-term goals, investing may be a better option that’s worth considering.
Investing: When should it be considered?
Investing savings means you have an opportunity to beat the pace of inflation with returns, therefore, preserving or growing your spending power.
However, investment returns can’t be guaranteed and short-term volatility can reduce values. For this reason, investing as an alternative to cash should only be considered if your goals are more than five years away. This provides an opportunity for investments to recover from potential dips in the market.
If you’d like to talk to one of our financial planners about the balance of your assets, please contact us or book a 15 Minute Discovery Meeting. Our goal is to align aspirations with financial decisions, helping you to strike the right balance.
Please note: The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.
