Is it time to cash in?
- 01 April 2020
- 5 mins
The values of all investments have fluctuated widely and rapidly in the past twelve months.
Those who are invested might be contemplating converting their investments to cash; those who aren't invested might be wondering when they should consider doing so.
But as we shall see holding cash is an investment decision in itself with its own pros and cons.
In a recent briefing entitled How much risk are you taking? we discussed how uncertainty about the near-term performance of investments could be making some clients nervous about investing. This could be due to such short-term worries as Brexit, tensions over international trade, and slowing economic growth.
Instead, they might remain on the sidelines, holding large amounts of cash on deposit, waiting for the ‘best’ time to invest.
Others could be considering cashing in their investments to sit out further short-term losses.
It might not seem like it, but cash is also an investment. And just like stocks, bonds, property and gold, there are benefits and risks to holding it, as we shall come to see.
Benefits of holding cash
Holding some cash makes a lot of sense as it allows you to meet your day-to-day living costs.
Holding a larger proportion of cash could also be sensible; in case you lose your job or have a long period of incapacity for example.
When trying to work out how much emergency cash you might want to set aside, consider your monthly outgoings and how much you need to live on a monthly basis.
As a minimum you should consider having sufficient emergency cash to cover at least three months’ average spending.
And if you are expecting to make a large expenditure in the next five years it may make sense to have the money for this readily accessible.
Finally, and depending on your age, income and experience, it could pay to hold some cash as a buffer in case of a major downturn in investments.
So if you need cash when the market is down, you do not have to cash your investments in at a time when they could be worth less than you originally invested.
It’s about understanding how much of your net worth you are likely to need at shortish notice, and how much of it you are not likely to need in the immediate future.
Ask yourself: how much can I afford to set aside for the next 5 to 10 years?
There are two other issues you should consider.
Inflation: the spectre at the feast
One powerful reason for taking a cautious approach when holding cash is the likelihood of it losing value. That might sound like an oxymoron but whilst money on deposit doesn’t lose its value in absolute terms, it can lose its relative worth.
This is because of the effect of inflation; and it could well be more expensive and damaging than you realise.
The measure of inflation used by the government and the Bank of England is the Consumer Price Index (CPI). This calculates the overall price of a selection of goods and services and compares its current value with how much it cost one year earlier.
In May 2019, the CPI rate of inflation was calculated to be 1.9%. In other words, if the selection of goods and services cost £1,000 in May 2018, the same selection would cost £1,019 one year later.
The consequence is that you need more cash a year later because the pound in your pocket doesn’t buy as much as it did a year before.
A CPI rate of 1.9% might not sound like much, and over the short term its effect is fairly small. But as time goes on the effect becomes increasingly damaging.
Chart 1 above shows how damaging inflation can be over a period of 15 years. For example, an inflation rate of 2.0% effectively reduces your spending power by £2,570 over that time.
It gets worse.
Many people consider the CPI to be a conservative estimate of the true rate of inflation.
Many consider the Retail Price Index (RPI) to provide a more accurate measure because it includes the costs of rental or mortgage payments which are excluded from the CPI.
In May 2019 the RPI was calculated as being 3.0%. Over 10 years, that would cost you the equivalent of £3,581.
What’s more, increasing trade restrictions and the UK’s looming departure from the European Union are contributing to expectations of higher import costs: in other words, higher inflation.
And it gets worse still.
The official inflation rate is only the average for the population as a whole. You will have something called your personal consumption expenditures price index (which is your personal inflation rate) based on your spending habits.
Electronic devices, clothing, mortgage rates and most manufactured goods have generally fallen in price over the past twenty years. Food, fuel, transport, services, and rents, however, have generally risen in price. Your personal level of inflation is influenced by how your budget is spread across these different areas.
For example, the personal inflation rate for a young person living at home is lower than the reported figure because most of their spending is on electronic devices and clothing.
But for the elderly it is higher because most of their budget is spent on food, fuel and transport; they generally have all the furniture and electronics they need so do not benefit from falling prices.
So holding high levels of cash for a long period of time is a potentially expensive decision unless you are earning more than your rate of inflation.
Missing out on potential growth
Which brings us to the second risk: the opportunity cost of missing out on the potential returns from long term investing. Remaining invested generally provides returns in excess of inflation and therefore contributes to preserving the spending power of your money.
And by long term we mean a period of at least 10 years.
By way of example, assume you’d invested in the FTSE All Share Index at the worst possible moment – the peak of the market on the 29th June 2007, the day before stock prices tumbled due to the financial crisis.
During the following two years, you would have seen your investment fall by 41%. At that point you might have been tempted to move your money into cash.
If you had, you would have locked in your losses.
Making sure you have enough cash to act as a buffer enables you to ignore the noise and drama and remain focused on your long-term objectives.
By not reacting in a knee-jerk fashion your hypothetical investment would have grown by 18% over the ten years to 29th June 2017, despite that fall in value through to early 2009.
To illustrate what we mean by long-term investing, we will take the FTSE All Share Index for our illustration. This contains all the companies in the UK in which members of the public can buy shares.
Its performance therefore reflects how most UK shares are performing overall.
Between 31 December 1986 and 31 December 2018 there were 281 rolling to-year periods. That is: 31 December 2008 to 31 December 2018, 30 November 2008 to 30 November 2018, and so on.
When we look at the returns for these 10-year periods, the FTSE All Share Index has delivered positive returns in 278 of them. This is illustrated in chart 2, above.
If you have more cash on deposit than you need, but you are nervous about committing to investing it, what can you do?
Steady does it
There is an investment technique that can be ideal for this situation.
It is known as dollar-cost averaging. This doesn’t mean converting your sterling to dollars before investing; it’s only called that because it was coined by an American academic.
It means contributing small amounts of money over a longer period of time rather than making a lump-sum investment.
The theory is when share prices are fluctuating you might buy some shares at a higher price, and some at a lower price: over the investing period you will achieve something between the two.
In this way you attempt to neutralise the short-term effects that come with frequent swings in the value of investments, because only a part of your total investment is exposed to potential losses.
It isn’t always the most profitable way of investing over the longer term but if your focus is on minimising losses it is a way of capturing some of the ups whilst minimising some of the downs.
Of course, you might still experience some of the losses and miss out on some of the gains but this technique can be a good way of avoiding major short-term losses.
So, is it time to cash in?
The answer will depend on your personal circumstances.
If you are not currently invested but you have capital that could be set aside for up to ten years, now might be the right time to buy into well-run companies when prices are low.
If you have identified how much you can afford to set aside to invest, and if your circumstances haven’t changed, selling at what might prove to be the bottom of the market might not be the best thing to do.
Also, selling your assets and holding cash over the longer term could increase your exposure to inflation. Especially while the interest earned on deposits is low.
Keeping your money invested can provide the potential to grow faster than the rate of inflation, and thereby help to counter the loss of value that inflation creates.
But investing also carries risks and investments can fall as well as rise.
Ultimately, it’s a matter of getting the right guidance or advice and this is where your Personal Wealth Adviser can help you create a financial plan that is right for you.
Forecasts of future performance are not a reliable guide to actual results in the future; neither is past performance a reliable indicator of future results. The value of investments, and the income from them, may fall as well as rise and cannot be guaranteed and the investor might not get back their initial investment.
Any views expressed are our in-house views as at the time of publishing.
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In preparing this article we may have used third party sources which we believe to be true and accurate as at the date of writing. However, we can give no assurances or warranty regarding the accuracy, currency or applicability of any of the content in relation to specific situations and particular circumstances.
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