Should investors resist the siren song of cash?

Our own Head of Multi Asset Funds John Roe recounts how his father recently asked him why he should bother investing when the banks can give him “similar returns without the worry.” The long and short of it is that a mixed pool of assets has historically offered investors a higher risk premium – and therefore the potential for higher long-term returns – than cash[1].

In the Asset Allocation team, we believe that risk is compensated over the long term, and that investors are more likely to earn a return greater than the risk-free rate (i.e. cash-like rates) over the long term when exposed to market/illiquidity risks.

We also believe that by spreading exposure to a range of asset classes (diversifying), investors can seek to achieve a smoother return profile than concentrating exposure to a very few asset classes. The investment industry is used to seeing different asset classes having their time in the spotlight, and cash is no different.

As shown in our recent chart of the month, Brits are currently finding cash more attractive with UK cash rates around 5%. Amid high levels of inflation, we have seen central banks hike base rates in order to slow economic activity in an attempt to bring inflation back down to target. This has led to higher interest rates from bank accounts and money market funds compared with pre-2021.

The role of cash

So should investors switch their investments to cash, and if so when? We have always seen cash as an important part of our portfolios for liquidity purposes. In addition, it can help to insulate portfolios from ‘tail-risk’ events by holding its value in nominal terms.

However, holding cash does come with a significant opportunity cost over the long term and we expect this to be the case even at the current higher rates. That’s because we still believe the long-term risk premium being offered by other assets such as equities and bonds to be higher than that of cash, and that this risk premium has the potential to translate into better long-term return prospects for multi-asset strategies.

Investors should also remember that holding cash provides no shield against unexpectedly high inflation and faces a high reinvestment risk given the speed at which cash rates can move. Additionally, market timing in volatile markets may be difficult and if rates come down again, the prospects for other assets could be very different from the ones we observe today.

That said, it is important to note that risk appetite and time horizon will vary by investor and today’s high rates being offered by cash may potentially be an appropriate investment option for more cautious investors as well as those with a short time horizon.  

A question of time

But for investors looking take advantage of higher cash rates now, and then move into potentially more prosperous asset classes over the medium term, is it possible to time this right? The research shows the reality is the overwhelming majority of investors do not have the ability to time markets, this leads to them missing out on returns.

In 2023 the impact of behavioural biases and unfavourable timing decisions led to an average of 0.32% underperformance for UK investor portfolios compared with a baseline buy-and-hold investment (Morningstar Mind The Gap Study 2023). This evidence supports the idea that most investors are better served staying invested in suitably risk managed portfolio rather than try to anticipate and follow shorter term trends.

Investment markets are typically leading indicators of the economic situation. Therefore, markets and investment returns may significantly improve when economic expectations change rather than waiting until the real-world economic situation actually improves, which typically takes longer. Behavioural biases also have a role to play when it comes to investors making decisions.

The first chart above demonstrates the key attraction of cash, which is the very low historical chance of making a nominal loss (based on data since 1945, before inflation is considered), whereas equities have made losses for periods of over five years.

As shown in the second chart, while equities can still make a loss after inflation is taken into account, the probability has historically declined with time. But the historical probability of making a loss from cash after inflation, stays high no matter how long the horizon. Interestingly, the historical chance of losing money from the 60/40 combination of equities and cash has been lower than equities alone, suggesting cash plays an important role for investors solely focused on real drawdowns

In summary, therefore while cash may be appealing for balancing equity exposure and short-term liquidity needs – not least given today’s attractive rates and its low risk of loss in nominal terms – we believe that in the longer term the risk of loss in real terms is a significant risk for clients to take on and that the risk premia being offered by other asset classes offers greater long-term potential.

[1] Past performance is not a guide to the future.