Question: Is cash really king? I have a large cash ISA, but am worried about the effect of inflation in recent years. What should I do?
The phrase ‘Cash is King’ rose to popularity during the market turmoil in the late 1980’s. The value of cash is two-fold; certainty and liquidity.
The outcome is certain
Cash provides certainty. Whilst nobody can predict what might happen in investment markets from one day to the next, if I deposit £100 into a bank account today I can be almost 100% certain there will still be £100 in my bank account tomorrow (let’s ignore the risk of bank collapse for now). For many individuals, holding cash feels ‘safer’ than taking the risk of investing in equities or other investments.
Liquidity = flexibility
When markets fall, having an element of cash within your portfolio, or in your overall balance sheet, will give you the flexibility to take advantage of a buying opportunity. If you can keep your emotions at bay, falling markets can be the best time to be buying in, not selling out, of investments.
Having cash reserves can also give you flexibility when you want to leave a job, move house or when you have unexpected expenses.
The crown has slipped
In the midst of the global financial crisis in 2008, central banks slashed interest rates to try and keep capital flowing and reduce the severity of the recession. We’ve not seen a true normalisation of interest rates since then and with rates remaining at low levels, the returns available to savers have been poor.
But this is about more than just disappointing returns from cash in the bank; interest rates on savings have been lagging inflation for over a decade, meaning that the real value of your savings, or their purchasing power, is falling. Whilst we have seen rates rise in the last 18 months or so, cash rates are still well below inflation which came in at 8.7% at the latest reading (May, 2023). It’s for this reason that many investors have been funnelling their cash into investments over the last decade, in the hope of achieving superior returns that will keep pace with inflation over the long term.
However, this doesn’t mean that you should get rid of all of your cash savings! Cash is another tool that individuals can and should use to manage their finances, both day-to-day and longer term.
How much cash is the right amount?
Whilst there’s not a magic answer that suits everybody, there are a few common rules of thumb that advisers will use when giving financial advice.
Have an emergency fund
The traditional recommendation would be to have at least 3-6 months of your spending need as cash on deposit (this is how much you spend on rent/mortgage, bills & living expenses). This should be held separately from your other savings and ring-fenced purely as an emergency fund. Your emergency fund is there to provide you with liquidity in the event of an unexpected cost or loss of income (your boiler breaks down or you lose your job, for example). Holding an emergency fund will give you peace of mind, allowing you to take risks elsewhere (for example with your investments) more comfortably.
Short-term expenses should be kept as cash
Keep cash in reserve for any known expenses that you’ve got coming up in the next 2-3 years.
For example, if you know that you want to buy a property or you have school fees to pay, you should be keeping any funds you’ve got earmarked for those expenses as cash, in a higher-interest account if you can find one.
The reason for this is that your time horizon is unlikely to be long enough to recover from any short-term losses in investment markets, should they occur.
Any cash outside of the above; consider investing
As I’ve covered already, keeping cash in the bank may feel like a safe option but you’re actually at risk of losing the value of your savings to inflation. If you’ve got a secure emergency fund and your known expenses for the next few years are covered, anything else you hold in cash could probably be considered as your long term savings. Whilst investment markets are volatile, and the value of your investments will fall as well as rise in the short term, history has proven that investing in financial markets is one of the most reliable ways to keep pace with inflation over the long term.
As with anything personal-finance related, there is no one size fits all. If you’re more comfortable keeping an emergency fund that will cover you for two years, do it! If you want to have no cash savings at all, or you want to have no investments at all, that’s also your choice to make, but make sure you’ve considered the risks (market falls for the former, inflation for the latter).
Date of publication: 30th June 2023
The information in this post is not financial advice, it is provided solely to help you make your own investment decisions. If you are unsure about whether an investment is appropriate for you, please seek professional financial advice. You can find more information here.
When you invest you should remember that the value of investments, and the income from them, can go down as well as up and that past performance is no guarantee of future return.