The economic landscape has certainly changed of late. Following an extended period of rock bottom interest rates (since the financial crisis of 2008), the Bank of England Base Rate has steadily increased from its all-time low of 0.10% in March 2020 at the start of the pandemic, to 5% today.
Whilst banks and building societies have been criticised for being slow to pass on rate rises to savers, cash deposit rates are now higher than they have been for many years. At the time of writing (July 2023), there are instant access deposit accounts offering over 4%, whilst a two-year fixed rate cash bond can offer over 6%.
Why invest in equities or fixed interest securities?
So, with cash deposit rates being this healthy, why invest in equities (stocks and shares) or fixed interest securities (government and corporate bonds)? The answer can be summarised in one word: inflation.
Of course, inflation is the reason for the increase in interest rates. The theory is that, by encouraging saving and discouraging borrowing, some of the heat should be removed from the economy. But inflation is the enemy of savings; it’s easy to underestimate the impact it can have on the real value of assets in the long run.
For any given window of time, the key is the difference between the average rate of return and the average rate of inflation. For example, if inflation is running at 8% a year and a cash deposit account offers 4%, by the end of the year, the spending power of the deposited capital would have reduced by 4% in real terms.
Another important consideration is the difference between cash deposit rates and the expected returns of an investment portfolio. In the short-term, this comparison can make cash look favourable. However, whilst investment returns can never be guaranteed, the expected long-term average annual return of a typical medium risk investment portfolio is 2.48% in excess of inflation, whereas the expect long-term real return of cash is -2.37% (data source: Distribution Technology Limited).
To put it another way, if £1000 were to be placed in an investment portfolio today, it could have a real value (i.e. in today’s terms) of £1278 in 10 years’ time, whereas £1000 placed in a cash deposit account could have a real value of £787.
That said, a corner stone of a solid financial plan is to hold a healthy ‘rainy-day’ fund in instant access cash deposit accounts – three to six months’ worth of regular outgoings is a rule of thumb, and more for those who are retired without guaranteed forms of income (e.g. state pension or a defined benefit scheme). It’s also advisable to hold enough cash to cover likely one-off expenses over the next five years. When holding cash, it’s important to remember the Financial Service Compensation Scheme (FSCS) limit, which protects up to £85,000 per individual, per institution.
Diversification is key
Once sufficient cash has been ringfenced, there is usually scope to invest surplus capital. Diversification is key – it’s advisable to hold a mixture of assets across sectors and geographical regions. As invested capital will fluctuate, investments should be entered into for a minimum of five years. Holding plenty of cash mitigates the risk of needing to draw on invested funds at a time when they may have dipped in value.
So, rather than choosing solely between cash or an investment portfolio, the ideal arrangement is often a combination of both. Cash provides security in the short term, whilst a well-constructed investment portfolio is likely to be one of the best lines of defence against inflation in the long run.
The information provided is for general information only and is not intended to address the particular requirements of an individual or business. It does not constitute any form of advice or recommendation by Menzies Wealth Management Ltd and should not be relied upon by individuals in either making or refraining from making any financial decisions. Where necessary, you should seek appropriate professional advice before acting on any of the information provided.
Past performance is not necessarily a guide to future performance. The value of investments and the income derived from them can go down as well as up. Investors may not get back the amount they invested.
Menzies Wealth Management is authorised and regulated by the Financial Conduct Authority (486548). Registered address: 1st Floor, Midas House, 62 Goldsworth Road, Woking, GU21 6LQ Registered in England and Wales 06597008.