Money for Nothing and Your Lunch For Free

In an economic climate where interest rates have soared to their highest in over a decade, the once-neglected cash is suddenly back in the limelight.

While the saying goes, 'there's no such thing as a free lunch,' the current high cash rates might make you feel as though you're dining without a bill.

But before you redirect your investments, it's worth dissecting what this means for your long-term financial strategy, especially if we are indeed seeing rates peak and begin to fall.

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For years, savers have been stuck in an unrewarding cycle, watching their money stagnate in low-interest accounts. But the tide has changed. Recent hikes have seen the Bank of England Base Rate increase by 3% p.a., narrowing the gap between inflation and interest rates. According to Bloomberg, as of September 2023, cash yields stand at 5.4% in the UK, compared to an inflation rate of 6.7%.

Cash has a place to play in your financial wellbeing, but it’s not the be all and end all.

What Is It Good For?

Well, obviously not absolutely nothing.

Cash is a great option for funding short term needs. Here’s why:

1. Firstly, cash is a very secure investment. The risk of not getting your interest and your capital repaid is very low. The security for money held with UK authorised bank, building society or credit union comes from government deposit guarantees which are capped.

2. Secondly, cash is liquid. You can get your money back very quickly at no extra cost or penalty, by selling your fixed income security or simply withdrawing funds on deposit.

What Doesn’t Cash Do?

Cash is unlikely to build wealth and meet your longer term needs. Other assets are much better suited to that job.

1. Cash returns are not linked to economic growth so there is no sustainable basis for income or capital growth. Returns are consequently lower in the majority of scenarios than other asset classes over the medium to longer term.

2. Unlike high quality fixed income, cash offers no effective diversification benefit in the scenario most associated with large falls in share prices: a deep recession. In fact, all prolonged economic crises have resulted in a reduction in interest rates, ultimately bringing down returns earned from cash.

3. Finally, the return from cash is only fixed in the very short term, changing when the Bank of England respond to new data that paints a different picture of current conditions and future inflation prospects. Fixed income securities offer much greater certainty of return on a buy and hold basis for cashflow planning, from a single year to more than 10 years to maturity.

Cash vs Equities

While cash might seem like a haven in turbulent times, it's important to remember what investment truly entails: long-term thinking and patience. As Warren Buffett wisely noted, "The stock market is a device for transferring money from the impatient to the patient."

12 months ago the best available rate was with Nationwide at 4%. Just 3 months before that it was 2.65% with Close Brothers.

Over the same 12 months, the FTSE All Share has returned 4.25% in capital growth and 3.96% in dividends.

Equities, unlike cash, are tied to the economic activities and potential of companies, offering the prospect of long-term capital appreciation. Even when cash yields are trending higher, this usually signals a heating economy, which in turn is beneficial for equities. When equities do struggle, it's often a temporary phase. For instance, the longest US stock market bull run lasted nearly 11 years, only to be halted by the Covid pandemic, before giving rise to a new, albeit shorter, bull run.

Cash investments also pose a timing challenge. Once you're out of the market, deciding when to get back in is often a matter of speculation, something even algorithmic models have struggled with. While cash has its merits, especially in offering better returns during challenging market conditions, other asset classes, particularly equities, have historically provided better returns over the long term.

Instead of turning solely to cash, consider diversifying your portfolio with income stocks. These stocks, particularly those with strong financials, not only offer dividend payments but also potential capital appreciation. Unlike cash, dividends have shown more resilience during economic downturns and can serve as a steady income stream.

Currently the Vanguard UK Equity Index fund has a yield of 5.4%.

In Summary

Does cash have a role in your investment strategy? Certainly. It offers liquidity and a degree of safety. But as a long-term investment option aimed at building wealth, it leaves much to be desired. The recent uptick in interest rates has restored its role as a short-term parking spot for capital rather than a long-term investment solution.

While cash yields may be currently enticing, they should not divert your focus from a balanced, diversified portfolio aimed at long-term wealth creation. It's not about timing the market, but rather about time in the market. So, before you make a bullish move towards cash, consider what you might be missing out on.