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).
The case for investing in equities is that over long periods in the UK (and even more so in the U.S.), equities have beaten the returns from all other asset classes.
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?
The holding we’re talking about here is as part of your portfolio diversification – not your emergency fund (which is a separate chunk of ready money stashed away for a rainy day or a blown boiler).
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.
On the other hand, income from government bonds is taxed, too, and a deposit account with a decent interest rate compares very well with low government bond yields.
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.
Readers: Is the humble savings account an under-rated asset class, or is the attractiveness of cash just a symptom of the ten-year bear market? Let us know in the comments below.
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Interesting article as this week I’ve been considering the cash aspect of my portfolio. I already have a sum of cash in a fixed rate bond, paying a good rate (4.5%) , and more readily available ’emergency’ cash getting just over 3%. Withdrawing cash to invest in government bonds or corporate bonds paying little more seems to make little sense. Cash is king for now at least.
.-= James Walters on: Guide to coding HTML emails =-.
On liquidity – you often have to use fixed-term savings to chase the best rates. Also, ahem, Icesave!
On fixed value – money illusion!
I can understand people using cash to hedge against life events: employment risks, unexpected house repairs, etc. I don’t personally keep much cash (maybe 1 months salary) and prefer to chuck it all into my investments. I look at 3% yield on cash and the 6% yield on e.g. a utility stock and start salivating for the divis.
That said, using offset mortgages and NS&I’s index-linked savings certificates are probably the best (only) way to invest in cash that I’d recommend for private investors: you get an inflation hedge, and avoid taxation in both cases.
Hi Lemondy 🙂 Yes, the very best rates are fixed rates – but they are still *cash savings* as opposed to true bonds, so zero volatility unlike gilts/bonds, and on the liquidity score you can get your money out of most now for a limited interest penalty. Which isn’t pure cash liquidity, granted, but has strengths and weaknesses versus gilts etc.
I have a follow-up post on the Investec High 5 account which I’ve postponed for a week or so in case everyone gets bored of cash… it’s currently paying about 3.25% and always pays the average of the top 5 UK savings rates. Very easy way to follow a decent cash rate without the faff; downside is £25K investment required.
My future post quotes defaqto research showing following the best rates (fixed rate savings ‘bonds’ (i.e. not real bonds)) yielded near 70% over the past decade, as opposed to 40% in an average savings account. (I’m spoiling the post here 😉 ). I could also quote Smithers and Co.’s recent research (Google: Why bonds?) which also sings the praises of cash.
Given the extra perks private investors get in cash (ISA sheltering, guarantees etc), I humbly submit your position in your final paragraph is too extreme. It is certainly the conventional one but we’ll have to agree to disagree. I know you’re holding all those gilts… 😉
On the IceSave front:
Firstly there’s no need to go into banks that aren’t FSA guaranteed, so it’s a non-issue (if you’re investing £500,000 in cash-like instruments and are starting to run out of independent FSA regulated banks, then fine, look at short term gilts!).
Secondly individual savers in IceSave were bailed out as I understand it anyway, even though it wasn’t regulated!
P.S. Re: Money illusion and utilities, yes, quite agree – I’m comparing cash to bonds here, and definitely not saying hold cash vs equities.
p.p.s. Thanks for your comment, hope you don’t mind the robust back and forth! 🙂
Would be interested on views about investing in new share issues by existing portfolio of VCTs offering tax free yield and tax breaks. Risky, but then keeping cash in sterling whilst the pound value keeps falling is a risky bet in itself. Northern 3 VCT looks interesting??
Personally, I make good use of savings accounts as part of my retirement investing strategy. Today I hold over 17% of my assets in cash. Of this around 5% is my emergency fund.
A large portion of the 17% comes from me lightening up on equities as my tactical asset allocation models suggest the stock market is over valued. This is currently going into cash for ready access if/when the stock market falls and allowing me to reinvest quickly.
The problem with cash today is that after inflation and tax it is impossible to get a real return, or at the very least stop your holdings losing purchasing power, if you go for a ‘no frills’ instant access savings account.
.-= RetirementInvestingToday on: Can the British pound fall any further? =-.
When Landsbanki went ker-boom Icesave-savers didn’t get access to their cash for a couple months. That’s the liquidity risk. A’course, brokers can go ker-boom too and the same could happen to my nominee account. Provided my broker is a going concern, I’m able to turn my equities and bonds into cash in a few days; this is the same order of magnitude as with fixed term cash deposits. (Heck, maybe even faster depending on what bank you’re dealing with!)
I do agree with most of what you’ve written. But I think people generally overrate liquidity of cash against other assets classes, overestimate the real return, and vastly underestimate the inflation risk. The “insurance” value of govt bonds still does it for me above all other fixed income assets.
@Lemondy – Okay, if there’s a bank collapse there’s liquidity risk but that’s not (usually!) an everyday/decade/generation event. And as you say it’s possible (perhaps more possible?) with brokers, too. You can turn equities and bonds into cash, but remember there’s a frictional cost of transaction that doesn’t exist with cash.
I think we’re partly having the debate because we’re coming at it from different angles – I think perhaps you mean the normal citizen over-rates/under-rates all those things (even if they don’t know the terminology). I agree most people on the Clapham Omnibus have too much in cash and are underexposed to equities. I’m more talking about sophisticated investors, who I think as I’ve said above have a tendency to over-complicate things and dismiss cash as part of their mix.
Thanks for the follow up!
@RIT – Yes, that’s the sort of strategy I think can work well for private investors, provided you’re prepared to rebalance when the opportunities come. Agree re: cash/rates/inflation (and Lemondy’s similar points). I don’t think it’s realistic to ever expect much more than 1-2% real from cash though.
@pkora – As one of those mythical people who owns a few VCTs (I was amused to discover I was near to half the average of the typical investor in VCTs than the other way, when I bought them), my short answer is avoid!
I bought them in a pique with Labour’s profligacy a few years ago, when you still got 40% tax relief and you only had to hold for three years. They’re less attractive now (though there are rumours of a hike up in the relief to come).
Northern are among the best – you could buy some of their VCTs in the secondhand market at 10% tax free yields in the chaos last summer, which gets you an immediate dividend stream but no tax relief. It was tempting but I didn’t want to tie up more of money.
VCTs are insanely illiquid – you can easily move the price selling just £1K of shares. Best to lock in the yield and throw away the key, at the risk of a slowly depreciating NAV.
Remember, I’m not an adviser, do your own research etc! 🙂
Re: Falling Sterling, I’ve actually got quite contrary about this and have sold off some of my most obviously dollar related shares in my trading portfolio to reinvest in domestic small caps. As far as I can see my optimism about the UK (relative to the absolute fire and brimstone projections – I’m not saying sunny uplands!) is playing out, and most of the exchange rate related stuff is in the price perhaps?
@James – Thanks for your comments. Personally, there will come a time when I’ll buy ten year Government bonds (or more precisely there will come a yield!) but as you say it’s not yet.
Mark Glowrey at the Fixed Income site is on the same page this week:
“For investors starting to build new portfolios, the situation is trickier. Reasonable yields of 5% or more can be locked in medium and long-dated corporate bonds, but pickings are slim in the shorter end. This makes it tricky to build up a balanced “ladder” structure of maturities for the portfolio.
This group of investors may be better off utilising some of the fixed-term deposits offered by several of the major banks for the short-end. These products are currently offering 3-4% and offer reasonable value for the shorter duration aspect of a portfolio. ”
You are Mark Glowery and I claim my £5!!!
(Here is a link to the whole article) http://www.fixedincomeinvestor.co.uk/x/analysis.html?type=Bond%20of%20the%20Week&cat=Analysis%20%26%20Comment
@OldPro – Would not a simpler explanation be that I read his article before posting? 😉 (I didn’t, by the way, but I agree with his reasoning. His already said in previous posts that he’s avoiding the long end of the curve and now he’s noting the short-end doesn’t look a bargain, either).
I do read his site though when I remember, I think it’s great. That graph of John Lewis bond yields over the past year is depressing. Alas I spent more time writing about the corporate bond opportunity in early 2009 than actually buying them! 🙂 (Shares did okay, too, though, if not such a historically extreme opportunity).
I don’t see any value in corporate bonds now, though I might end up shifting some money into something like the 5-year RBS royal bond at 5% if equities go much higher. I’m woefully under-diversified.
Well you answered my question (along with Investor Junkie and Evolution of Wealth and Engineer your Finances) that my cash should go into a High Yield Interest Savings Account. Now I need to scout one out. I love all the information you all feed my brain – Makes me think and hopefully will one day make me wealthier from the info I learn about. 🙂
.-= Money Funk on: Certificate of Deposit: Good Investment? =-.
Not bad; too many investors seem to forget about having cash to help cushion their portfolios, and this is a nice reminder. Doesn’t have the same flair and pizazz as stocks, but then, that’s part of the point.
.-= Roger, the Amateur Financier on: What Classic Sci Fi Can Teach Us About The Future =-.
I would be interested to here how people holding large volumes of cash temporarly in a ‘share ISA’ or SIPP can get a decent return on cash e.g. better than zero. My ‘share ISA’ holdings are all cashed up as I am very worried about the market, yet because of the wrapper I cannot move it all into a savings account. Can any specific fixed interest or indexed linked ETF’s help here without to much risk?
@Stephen – Interesting question, to which I don’t have a ready answer as I am always fully invested in my stocks-and-shares ISAs, and haven’t looked across the market at such products for a long time.
In general though, as I understand it, cash-like investments – even funds, like money market funds, and short-dated gilt funds – have to be held in cash ISAs.
In practice you can probably sit in cash for a while on the grounds you’re waiting for an investment opportunity to come up (i.e. cheaper shares!) but you’ll be hit by inflation.
I’d probably explore cautious investment trusts like Personal Assets, but that could still halve in value in a crash.
None of the above is personal advice, just my general thoughts, please remember. I don’t know your circumstances and am not qualified to give advice.
@The Investor
Do you have a list of the best cash ISA accounts on monevator?
@emanon — No, we haven’t the resources unfortunately.
@The Investor
No worries. I’m basically ready to put my asset allocation into practice. The one thing that has delayed me is my understanding of bonds of which i have a good enough grasp of now, what i don’t have a grasp of is how these compare to holding cash instead, if i can reduce my risk by holding cash then i will.
Another question is if the equities markets take a hit as a passive investor do you then replace your holdings in cash for gilts or is that simply a case of chasing higher returns which could get ugly?
@emanon — Gilts are bonds not shares. If the stock market (equities/shares) fell you’d normally top your allocation to shares up (add to them) when you come to rebalance your diversified portfolio. See this article, and the others in the series (box top right): http://monevator.com/the-simplest-way-to-rebalance-your-portfolio/
You can certainly follow that approach if you like The Investor. Personally, I prefer bond indexes because they fluctuate in price. As such, by rebalancing, I get more than the yields in overall profit. For example, when equity prices rise, bonds usually drop and vice versa. When rebalancing a bond index over many years, you can capitalize on those price movements. Vanguard UK’s bond index has earned roughly 27% cumulatively since 2009, which is much more than a bank account would have paid. Those rebalancing it in a portfolio would have earned slightly more. Best of all are the price fluctuations. For 2013 (for example) it’s down just over 2%.
@Andrew — Bonds have their place, and this website is stuffed with articles explaining their virtues — and urging recency-biased investors to think twice before ditching them for more shares.
But there’s a time for all things, and also mathematics for all times, too. In today’s ultra-low yield environment, private investors have been easily able to get a better yield on cash, without risking excessive downside from the slow unwinding of the bond bubble.
What’s more — as I seem to spend half my life writing — it’s not either/or. You can have bonds and cash, as well as equities and so forth.
As for an excess rebalancing gain, sometimes you’ll get it, sometimes not. See this post doing the maths from Rick Ferri.
The chief benefit from bonds is risk/volatility reduction, and especially in a low-rate environment cash can be a substitute.
Investor, you sound like a market timer, if you’re interested in choosing the right time or the wrong time to buy bonds. John Bogle says he doesn’t know anyone who even knows anyone who has done that consistently. I prefer setting an allocation, and sticking to it. That way, I never have to speculate, allowing me to invest and rebalance as dispassionately as possible. It has allowed me to do much better than most people (dare I say more than 95% of investors?) during my past 25 years of investing.
@Andrew — I’m not interested in a tit for tat scrap. My comments and views are perfectly reasonable.
You “sound like” someone who turns up to cause arguments by advocating your way or the highway.
I think we’ve both said our piece here.
Thanks Investor,
I certainly didn’t mean to come across as an aggressor. My apologies for that.
Cheers,
Andrew
The Investor,
If you replace bonds with cash, you will make an even lower return over time. In addition, you won’t be able to take advantage of rebalancing. When stocks rise, bonds often fall in price. Cash won’t. You will want to sell stocks (after they have risen) to buy the cheaper bonds when rebalancing.
In the past five years, £10,000 grew to roughly £12,600. You would have had no such luck with cash, on which you would have made nothing.
@Richard — Hi, yes, that’s the advantage of bonds. See some of the articles we’ve written to that effect via my link below.
However cash has its own role, especially as private investors. For instance, your comment that over the last five years you would have made “nothing” in cash is flat wrong. Even in these straightened times has been possible to get 2-3% per annum on cash on relatively large sums of cash as a private investor, albeit with a fair bit of hassle. Furthermore if you’re an institution government bonds are safer than cash, whereas as a private investor your cash is fully protected via the FCSS. This is another huge advantage.
Also your comment “If you replace bonds with cash, you will make an even lower return over time” should read you *may* make even lower returns over time.
It’s true that over the past history, returns from bonds have been higher than for cash for institutions. However this is not so clear cut with private investors, and in addition nothing is certain enough for “will”, particularly given the very low starting yields on bonds. I’d say it is entirely possible cash will beat bonds for at least a couple of years once interest rates start rising, though we’ve all been waiting for that for a long time of course! 🙂
Finally, this article is about the cash from a timeless perspective, not just from the POV of this very low yield environment of the past five years, in which interest rates have hit 300 year lows and bonds have risen to levels that were not really thought possible by conventional economic thinking of the past 100 years or so. (E.g. Negative interest rates briefly on German 10-year government bonds etc). In the first decade of the 2000s, private investors could easily get 5%+ on six-figure cash sums, which compared very well with both equities and bonds.
But yes, in case you’re new to the blog we do cover bonds, and have in fact defended their allocation in passive portfolios many times. The article “A Brief Guide to the Point of Bonds” in the list below is perhaps our most comprehensive.
http://monevator.com/tag/bonds/
Finally, I’m sure your bond return figure is well-sourced, but it would be helpful if you said which bonds you are talking about when citing bond returns… 🙂 As you know, there are many varieties, from government to corporate, investment grade to junk, and all the duration variations too.