Cash is King – or is it?

There is a saying in the investment world: Cash is king! Without cash, purchases can’t be made, debts cannot be settled, and dividends cannot be paid to shareholders. In this respect, cash is indeed king, and it always will be.

Is cash king during periods of high inflation?

No. In other respects, cash’s crown has slipped. With interest rates collapsing in the aftermath of the financial crisis in 2007 and subsequently remaining at low levels for a long time, returns on bank and building society accounts have been poor for much of the past decade.

More recently, interest rates on the best savings accounts have been increasing, but in the long term it’s tough to keep up with inflation using cash.

As the chart below demonstrates, cash has produced a very modest positive return over the last ten years but, against inflation it has failed to keep up. People’s spending power has gone backwards over the longer term.

Chart: £100 indexed according to UK Consumer Price Index Inflation and return on short-term cash deposits over the past decade.

Source: FE Analytics, 31/12/2012 to 30/12/2022

How much cash should I have in savings?

Having cash reserves is important. Most people need a “rainy day” fund to cover unforeseen events – say 3 to 6 months income. For the purpose of saving towards shorter-term goals, cash is appropriate too because it has the significant advantage of offering the security of capital.

Some investors also like to hold some cash to take advantage of opportunities in the market as they arise. Yet as the above chart shows, holding too much cash for long periods can be costly. Inflation can gradually eat away at its spending power and the relentless cumulative effect over time can be detrimental for those keeping large sums in cash and attracting interest at a lower rate.

For instance, each £1 you spent in the year 2000, you would need to spend £1.82 today. Earning a competitive rate of interest on cash will help, and just lately rates have been rising, but by keeping too much in cash for long periods investors could be at risk of not making the most of their money – or not achieving their long-term financial objectives.

What is the best thing to invest in?

It's important to set goals for different ‘pots’ of money and consider whether they are short-term or long-term in nature. Shorter-term needs are generally considered to be less than five years, perhaps putting money aside for a new car or for a house deposit for example. Longer-term goals include getting ready for retirement or making provision for school or education fees likely to be incurred in ten or more years’ time.

Short-term needs are best addressed through saving cash and long-term ones through investing. Unlike cash, riskier assets do not offer the security of capital, but over the long term they tend to do better and therefore they build wealth more effectively. Striking the right balance between risk and reward is something every investor must consider and revisit periodically – it’s important to make the most of money, but it’s also vital not to lose sleep over it. It means having a financial plan and regularly reviewing it to check it is on track, as well as taking on the appropriate level of risk.

However, your bank may not be the best solution for all of your cash. Even with the recent increases in interest rates, its deposit rates might not be among the best available. Smaller banks and building societies and “digital” banks compete for savers’ cash by offering better rates. If you don’t want the hassle of hunting around for competitive deals, an online savings platform can do the hard work for you. Depending on your near-term plans a mix of easy-access, fixed-term, and notice accounts can provide both flexibility and better returns.

See what savings rates you could get with Charles Stanley Direct Cash Savings.

Long term alternatives to cash

In the longer term, even low levels of inflation can stealthily rob you of your spending power. The good news is a well-diversified investment portfolio can help preserve and grow a nest egg amidst the ravages of inflation.

Unlike cash, riskier assets do not offer the security of capital, but over the long term they tend to do better than cash in providing a return above the rise in the cost of living, and therefore they build your wealth more effectively. Although it can be daunting to make the switch from saving cash to investing it, it can be beneficial in the long run. Once you have a good cushion of cash savings, it may make sense to invest any surplus.

Shares are more likely to outperform cash the longer you invest. Company earnings have the potential to grow faster than inflation over the long term, and this can drive both share prices and dividend payments higher, though unlike cash the value of investments and income can fall as well as rise so you could get back less than you invest. That’s why investing is only for those prepared to commit for the longer term – five years as a minimum – in order to have a better chance of riding out market ups and downs.

Cash has a place in everyone’s financial plan, that is not in doubt. But it should form part of that plan, not dominate it. There are alternatives, and some of them are not as risky as you may think – so long as you’re prepared to think long-term. For instance, multi-asset funds offer a diverse portfolio in one convenient investment and aim to beat inflation by various amounts according to the amount of risk you are willing to take – however all investments can fall as well as rise, especially over the shorter term.

Want to make the most of your tax allowances this year? Find out more about using ISAs, SIPPs and investments to save tax.