Cash is a fickle asset class, which can be characterised as the “Jekyll and Hyde” of the investing world. Its best “Dr Jekyll” moments tend to come during times of market turmoil, such as in 2022 when bond and equity markets both fell. It is also championed for the near certainty of its returns, at least before the effects of inflation are taken into account.

But there is a hidden, dark side to the character of cash. Its evil “Mr Hyde” persona is reflected in its poor track record of maintaining or growing purchasing power over time. The chart below demonstrates this well, by comparing how cash performed during the Global Financial Crisis (2007-2009) to how it has performed since then.

While equity markets suffered a severe loss of confidence during the financial crisis, cash continued to deliver a modestly positive real return (after inflation), even though interest rates were cut to close to zero as part of the policy response. Over the longer period, however, from the start of the crisis to November 2023, 27% of its purchasing power was eroded by inflation, while the real value of “higher” risk global equities more than doubled, even when measured from the height of the market before the crash.

The problems with timing the market

It may feel tempting to want to hold cash that pays a seemingly decent rate of interest, particularly at times when the stock market is about to succumb to one of its periodic bouts of weakness. A key problem is knowing when the timing may be right to take this action. Nobody rings a bell telling us when to buy or sell any asset class – if only it were that easy. That is why reacting to short-term events is rarely the right thing to do in investment.

In 2022, when bonds and equities both fell, driven to a large extent by the rapid rise in inflation to double-digits and the subsequent increase in both interest rates and bond yields, some investors may have been allured by the safe, secure, “Dr Jekyll” aspects of cash. After all, for the first time in more than a decade, deposit holders were able to receive a reasonable rate of interest of, say 5% or more, on their cash savings.

However, by the time interest rates had risen to 5%, bond and equity markets had already bottomed and were in the process of recovering. So, to sell out of a market-based investment portfolio to buy cash in 2022-23 would have involved locking in some or all of the losses. It is also worth remembering that the headline interest rates on bank deposits are stated gross, but these are rarely what is achieved in practice, after tax. As most clients will be higher-to-additional rate taxpayers, we have to bear in mind the reduction in personal savings allowances for tax free interest. For additional tax rate payers, this allowance is removed entirely.

Meanwhile, with respect to bonds, it should be remembered that the longer we lend our money for, the higher the interest rate or yield we should expect to receive. This is the case whether we are depositing with a bank or buying a bond. It is known as the “term” premium and is one of the reasons why bonds have a different role to play in a portfolio than cash. The term premium should result in a modestly higher long-term return when lending for slightly longer than cash will typically allow.

In addition, at times of equity market stress, money tends to flood out of risky assets and into high quality bonds, driving their prices up. This doesn’t always happen, of course, with 2022 being a notable recent exception where the opposite occurred. However, this “negative correlation” between bonds and equities has been regularly seen during periods of market crisis in the past, and it allows bond investors to receive both capital gains and yield, providing a defensive fillip not available to those holding cash, who just receive the interest.

Lead us not into temptation

Although the perceived safety of cash can have a strong allure, the chart above powerfully demonstrates why long-term investors should avoid the temptation to hold cash as an alternative to a carefully-constructed, globally-diversified portfolio of systematically-managed funds, with a sensible balance of asset classes, all playing different – but complementary – roles.

Below, we look at what’s happened since the start of 2023 to make the same point in a different way. Very few commentators were predicting this, but equity markets have enjoyed a robust recovery since the turmoil of 2022. Cash may have felt like a comfortable place to be at the start of 2023, but an investor holding large quantities of it will have left valuable returns on the table.

If investors are tempted by the relative security of cash, they would do well to remember that there is no market timing bell, and there is no knowing what markets will do next. Trying to second guess the market is a challenging sport with few winners.

Cash may have a role to play in everyone’s overall portfolio of assets. It offers essential liquidity to cover short-term expenses and can provide a buffer for unanticipated life events and emergencies. But that is a very different role to that played by bonds, equities and commercial property. In combination, these assets are much more likely to deliver your long-term financial goals, particularly when it comes to maintaining or growing the purchasing power of your portfolio over time.

Simon Bruce
Chair of the Investment Committee