Is your money better off in cash?
Tempted by high deposit rates?
You will have a good idea of how much cash to keep in the bank for day-to-day and rainy-day needs, but the best potential for your money comes from your investment portfolio as opposed to deposits:
Deposit rate may seem attractive at present, but this is not the case in real terms.
Current interest rates seem like an exception, but not so in historical terms.
Putting cash into term deposits may cost more in terms of returns that you might think if you attempt to time your entry into an investment portfolio.
Cash and your portfolio
You will have your assets invested in a way that they are most likely to meet your future financial objectives. For the majority of people this involves a portfolio of equites and bonds. Cash is put aside for short term requirements or for emergencies in a way that is appropriate to your individual circumstances. This provides surety of your capital, but doesn’t account for the impact of inflation.
Current interest rates and inflation
After a period of low interest rates following the global financial crisis (GFC) in 2008, we now have a level of interest rates that offer 12-month term deposits of around about 6% (1). At face value, this might seem attractive. However, if one considers the current rate of inflation of 6.4% (2), then that current deposit rate is negative in real terms. By locking up your money for 12 months or more, you are betting that inflation comes down to an extent where the return is positive. Therefore, your term deposit is not ‘risk-free’, as there is a risk that the rate of inflation may continue to reduce both the spending power of both the interest and your capital.
Current rates are not exceptional in historical terms
There could be the temptation to think that current interest rates are an exception and therefore represent a better medium- or long-term investment given the recent returns from an investment portfolio as a result. Looking at information from the Bank of England (3), the average base rate for the ten years up until the beginning of the GFC (Oct 2008) was 5.11% and the twenty years up until then, 6.49%. Even if one includes the period of exceptionally low rates from 2008, the average rate for the thirty years to the end on 2022 was 4.39% and, despite these higher interest rates, equities and bonds have historically represented better value investment than cash deposits over the longer term.
Investment portfolio returns
The chart below shows the respective returns of differing types of investments, including cash deposits over a 30-year period to the end of 2022:
Even considering that for many years during the thirty-year period shown above, interest rates were significantly higher than the average since 2008, historically, equities and bonds offered superior returns. The table below demonstrates those returns over an even longer time period and the impact of inflation on those returns. Although this length of data is just available for the UK market, this period included significantly higher levels of interest rates than were evident in the chart above. Of course, any charges associated with investment which may have impacted those returns. should also be accounted for.
Equities and bonds do not give the capital security that cash can provide. Your capital is at risk. The value of your investment (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investments, therefore, should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.
Naturally, equities and bonds fluctuate in value, which is why they should be held for the longer term (at least 5 to 10 years). Trying to time an investment to switch from cash to these assets is notoriously difficult and doing so brings its own risks to potential returns. The following chart demonstrates how trying to time the market can lead to returns being compromised (we have used the U.S. S&P 500, as the U.S. market represents over 50% of the world’s stock markets by value):
Why do equities do so well over the longer term?
At a basic level, equity investors benefit from GDP (economic) growth, earnings growth and inflation:
GDP Growth: If an economy is growing, then companies can benefit from that growth through extra business.
Earnings Growth: Companies aim to grow their profits each year and pass these onto shareholders, either through a higher share price or dividends.
Inflation: Many companies, as we have seen recently, have simply passed on the increased costs they incur through inflation onto their customers. This is then reflected in their profits.
The risk of damaging returns by holding your money in cash
We have already seen how damaging trying to time entry into the stock market can be. The following table shows the results of analysis of the possible effects of investors keeping their money in cash instead of putting it into a 60/40, equity/bond portfolio over different time frames and over a longer period of time:
As can be seen, there is a risk of reducing your investment returns from your portfolio the longer it is kept out of the market and in cash. Worse, term deposits usually require money to be locked up for a fixed period, exacerbating this effect.
Opportunities in bonds?
Finally, the change in the underlying interest environment, while very challenging for investors in bonds during a period of rising rates such as in 2022, does now throw up some potential opportunities for the future as we approach a likely peak interest rate. The graphs below show both the negative impact of a rising rate scenario on bonds with different expiry dates and the positive impact of a declining rate environment. This is because the rate of return from a bond is fixed, so as interest rates decline that fixed payment potentially becomes worth more to investors and the price of the bond will reflect that. Bonds with longer to expiry have a greater sensitivity to those changes in rates, so investment managers can choose the most appropriate expiry to suit the expected environment.
Conclusion
While the change to the interest environment since 2021 may seem to make cash deposits more attractive, it is important to remember the impact of inflation on these returns. If rates go down longer term, so will returns from cash on deposit. Likewise, these now higher rates should not distract from the longer-term benefits of an equity/bond portfolio, which offer far superior returns over the medium to long term.
1 Money.co.uk 22/8/23.
2 CPI. Source: ONS 16/08/23.
3 Bank of England base rate database 23/08/23.
This article is issued by Journey Invest Limited, September 2023. Its content is for your general information purposes only and does not constitute investment advice. The commentary is intended to provide you with a general overview of the economic and investment landscape. It is not an offer to purchase or sell any particular asset and it does not contain all of the information which an investor may require in order to make an investment decision. We cannot accept responsibility for any loss as a result of acts or omissions taken in respect of this article.