Article

Is cash really king?

The relentless effect of inflation over time can be detrimental for those keeping large sums in cash and attracting interest at a low or even zero rate.

| 7 min read

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.

Yet in other respects, cash’s crown has slipped. With interest rates collapsing in the aftermath of the financial crisis in 2007 and staying at ultra-low levels ever since, returns on bank and building society accounts are negligible. That’s still the case today even though inflation is picking up once more.

It continues a trend of the gradual erosion of the spending power of cash. As the chart below demonstrates, cash has produced a very modest positive return over the last 10 years but, against inflation – rises in the cost of living – it has failed to keep up. People’s spending power has gone backwards, something that has really accelerated over the past year.

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

UK Consumer Price Index Inflation graph

Source: FE Analytics, 04/01/2012 to 04/01/2022

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 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 the 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, for each £1 you spent in the year 2000 you would need to spend £1.72 today. Earning a competitive rate of interest on cash will help, but it is currently impossible to earn an inflation-beating amount. Therefore, by keeping too much in cash investors could be at risk of not making the most of their money – or not achieving their long-term financial objectives.

Setting goals

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 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 that 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.

The future for cash

Sadly, there appears little respite on the horizon for cash savers. In the UK, Consumer Price Inflation (CPI) is running at an annual rate of 5.1% and is expected to reach 6% by April – that’s three times the Bank of England (BoE) 2% target. Ordinarily, these sorts of rises in the cost of living would prompt steep interest rate rises – meaning greater returns from cash in bank and building society accounts. However, while rates might rise a bit more – the BoE recently put them up from an all-time low of 0.1% to 0.25% – it’s unlikely savers will be well compensated for price rises when the priority is to keep the post-Covid economy on track.

This higher inflation is predicted to moderate, possibly quite quickly during the course of this year, but it is likely to put a significant dent in the spending power of cash in the bank or building society in the meantime. In the longer term, even low levels of inflation can stealthily rob you of your spending power over longer periods. The good news is a well-diversified investment portfolio can help preserve and grow a nest egg amidst the ravages of inflation.

Long term alternatives

Unlike cash, riskier assets do not offer 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.

Find out about how you can be more invested in your future this tax year.

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Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

Is cash really king?

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The information in this article is based on our understanding of UK Legislation, Taxation and HMRC guidance, all of which are subject to change. The tax treatment of pensions depends on individual circumstances and is subject to change in future. This article is solely for information purposes and does not constitute advice or a personal recommendation.

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