I believe cash is king of the asset classes, which might come as a surprise given that I most often talk about investing in equities (by buying shares in companies).
But equities are a necessary evil that come with big downsides:
- Equities are volatile, so you can lose a lot of money in a short time period.
- There’s relatively high costs involved in buying and trading equities, even in cheap index funds.
- If you buy individual shares you can lose all your investment (though this risk is easily avoided by using an index tracker or an ETF portfolio).
But investing isn’t just about getting the highest returns.
Cash beats equities on several important measures:
- Liquidity – Money is the most liquid asset.
- Fixed value – You always know exactly what your savings are worth.
- Simplicity – Anyone can open a savings account.
- Security – Governments usually protect savers’ deposits.
- Cheap – Saving and withdrawing using a deposit account is free.
These same advantages apply comparing cash to bonds, too.
But bonds do win in one important respect – security of income.
When you buy a fixed-interest government bond, you know exactly what return you’ll get provided you hold the bond until the end of its life.
In contrast, returns from savings accounts vary as interest rates go up and down.
What this all means for your portfolio
I believe financial advisers and writers typically underestimate how useful cash is in a private investor’s portfolio.
If you look at popular ETF portfolios, for instance, only the Permanent Portfolio includes any cash (a substantial 25% of the portfolio, in that case).
Model portfolios from private wealth managers generally suggest less than 5%.
That might be mathematically sensible based on expected returns, but I don’t think it takes advantage of the unique position of individual investors.
One reason why even model portfolios aimed at private investors may skimp on cash is because they are based on the big diversified portfolios of institutions, for whom a large holding is impractical. Instead, institutions hold bonds.
But we private investors get special perks:
- Savings accounts are usually free.
- Deposits are guaranteed (up to £85,000 per FSA-approved bank in the UK).
- Tax-free savings are possible (via ISAs in the UK).
- Bonus higher interest rates are always on offer.
None of these advantages apply to institutions.
Also, as private investors we will only ever be handling relatively small amounts of money, compared to a fund managing millions.
We can easily move our money from account to account to chase the best interest rates, pay nothing to do so, use tax-exempt accounts, and enjoy full protection of our savings. (UK investors see this page for full details of the FSA compensation scheme).
Indeed, recent research found that a UK investor chasing the best saving rates from 2000 to 2010 would have seen their money grow by a very impressive 70%.
So how much cash should we hold?
As ever with asset allocation, there’s no firm rules, whatever an expert may tell you. In fact, as we’ve discussed many writers don’t include any cash in their model portfolios at all.
Personally, I think for small and new investors, a competitive savings account can entirely replace the hassle of buying and holding bonds. I suggest new investors just split their monthly savings between a high interest savings account and an index tracker.
For investors with more money to stash away, the decision is far more difficult.
When interest rates are very low, the returns from a savings account are pitiful, especially after tax. Also, following a period of poor returns from equities there’s a good bet that shares will outperform by some distance.
Equities should clearly be the focus for long term saving and investing, with periodic rebalancing as you see fit. Play too safe and you’ll likely regret it, especially once inflation is taken into account.
Personally though, unless and until government bond yields are sufficiently high to compensate for their extra volatility and trading costs, when it comes to fixed interest I’m happy to hold cash instead.