Why you should think twice about making a big move to cash

Over the past two years, on the back of sharply higher UK interest rates, the savings and investment landscape has changed. For the first time in well over a decade, cash is viewed as king. Around 5% a year is available on certain savings accounts for those willing to shop around. Those returns appear very attractive, given that your money is secure and protected from market gyrations.

As part of a diversified portfolio, cash is a useful asset class in its own right to help guard against stock market volatility. Cash and bonds form the defensive parts of a portfolio. Moreover, having a small cash position is prudent for when you spot new investment opportunities.

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However, in terms of forming a broader role in a portfolio, cash should not be viewed as king over the long term.

Why cash does not trump investing over the long term

Cash is not the risk-free option many assume it to be. Its Achilles heel is that inflation slowly but surely erodes its real value over time.

The latest UK inflation reading, for October, is 4.6%. However, over the past two years inflation has been much higher. Therefore, for most of that time those who have moved to cash have been receiving negative “real” returns. In other words, making a loss.

Of course, while there are no guarantees, the history books tell us that the best way to stop your money eroding is to invest.

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Time in the market, not timing the market

Investing for the long term and holding your nerve during periods of short-term market fluctuations are key to increasing the chances of investment success. This old adage still rings true today, and “it is not about timing the market, but about time in the market”. One of the big benefits of staying invested is the wonder of compound interest – the way investment returns themselves generate future gains.

Moreover, in terms of market timing, those looking to switch investments into cash today may be doing so at a time when the latter’s crown is starting to slip. The expectation is that central banks are at the peak of their interest-rate hiking cycles since inflation has cooled from red-hot levels. In addition, central banks are keen to avoid a scenario where further interest rate rises tip economies into recession in 2024.

Over the next couple of years the likelihood is that the direction of interest rates is down, although we’re unlikely to return to the days of ultra-low rates.

While only those with a crystal ball can predict what the new normal will be for borrowing costs, the outlook for cash in the years ahead looks less appealing than today.

In the short term, there’s less opportunity cost of sitting in cash when 5% can be earned, but over the long term the chance of cash beating investing reduces significantly.

Options for those who are cautious to stay in the market  

As well as the eye-catching 5% that can be achieved on some cash products, another reason for moving to cash is to reduce risk. This is particularly prevalent right now given the risk of recession in 2024.

However, there are various ways to invest cautiously while remaining in the market.

Money market funds

The reality is that every investment carries an element of risk and there are no guarantees a return will be achieved. However, at the most cautious end of the risk spectrum are money market funds. These funds own a diversified basket of very low-risk bonds that are due to mature soon, normally in under a year. They can also put money into bank deposit accounts. As a result, investors can earn an income on their cash with minimal risk.

When interest rates rise, the income generated by money market funds increases, causing fund yields to rise. Therefore, bear in mind that if and when interest rates are cut, the yield on money market funds will fall.

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Fund industry trade body the Investment Association (IA) categorises money market funds into two camps: short-term and standard term funds.

Short-term funds are lower risk. Fund managers try to ensure the highest possible level of safety by keeping very short duration bonds and high-quality bonds in the portfolio.

Five money market funds yielding 5% plus on the ii platform

Source: Yield figures sourced from fund provider factsheets. Data to 30 October 2023. Past performance is not a guide to future performance.

Advantages of a money market fund

• Very low risk, with the portfolio likely to at least hold its value and also pay out an income
• Diversified, meaning investors are not exposed to a single bond failing and can withdraw their money easily
• Fund managers are potentially in a better position than individual investors to spot attractive interest rates and invest in worthwhile short-term bonds
• Can be held in a tax-friendly wrapper, such as an ISA or SIPP.

Disadvantages of a money market fund

• Investments may fall in value, unlike savings accounts. There is also no £85,000 Financial Services Compensation Scheme protection, which the government guarantees on bank deposits
• Not suitable for growing savings over the long term as yields are typically below inflation
• Sensitive to interest rate fluctuations, with lower rates leading to lower yields. Yields rise when interest rates rise
• The Bank of England warns that in times of market panic, there may be liquidity issues in money market funds.

Gilts

UK government bonds or gilts are another low-risk investment offering a lot more income than they have for a long time in response to rising interest rates.

Investors buying gilts are lending money to the government, known as the principal, which operates like an IOU. While waiting for the money to be repaid at a specified date in the future when the gilt matures, investors are paid interest at a fixed rate known as the coupon. This payment typically happens twice a year.

• Everything you need to know about investing in gilts

Gilts are lower risk compared to other bond types – such as corporate bonds – due to the security of the issuer, which is the UK government.

In 2023, there’s been a preference among interactive investor customers to buy gilts set to mature in the next couple of years, such as bonds maturing in 2024 and 2025. This suggests that investors are holding the gilts to maturity, locking in yields of around 5%, or slightly higher in some cases.

ii offers gilts on its platform, which you can browse here. The most popular ones can be traded online, while some may have to be traded over the phone.

Advantages of gilts

• The ultimate low-risk investment due to the security of the issuer, the UK government
• Provide investors with a predictable income stream, with coupons typically paid twice a year
• Capital gains from selling a gilt, or when it redeems, are not subject to capital gains tax. This makes them a useful tax-planning tool for investors who have used their ISA and SIPP allowances.

Disadvantages of gilts

• Understanding how to buy gilts, and how they are affected by markets, is not always straightforward
• Inflation potentially erodes the real return of gilts
• Lack of diversification if you buy only one, or a couple of gilts. For example, gilts with longer-term maturities are more sensitive to interest rate movements. Therefore, it may be more prudent to spread risk by buying a range of gilts with different lengths of maturity.

Bond funds

To achieve diversification, most investors prefer to outsource the decision-making to a managed bond fund. This is either run by a fund manager who builds a portfolio of bonds, or it is an index fund or exchange-traded fund (ETF) with a passive approach and simply tracks the fortunes of an entire bond market.

There’s a huge number of bond funds with various strategies. A good starting point is to look at the bond funds that ii analysts deem best in class on our Super 60 list of fund ideas.  

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Some flexible funds are able tomix and match any type of bond, such as government bonds, investment-grade corporate bonds and high-yield bonds. Two examples in our Super 60 list are Jupiter Strategic Bond and M&G Global Macro Bond.

It may also be worth looking at a new bond fund from our parent company abrdn. The fund, called abrdn Short Dated Enhanced Income Strategy will aim to beat cash returns, with low volatility compared to other bond funds. In an interview with ii, fund manager Mark Munro discussed the strategy, covering the risks involved, why it was launched, and what income investors can expect if they own it. You can watch the video here.

Equity income

And finally, equity income investing has been an effective strategy to beat inflation over the long term.  

In our Super 60 list, we have a handful of UK equity income options, many of which have yields of 5%-plus. Equity income funds provide dividend growth, which bonds and cash do not deliver because the interest payments are fixed. It is growth in income that protects against inflation over time.  

Moreover, there are many individual companies in the FTSE 100 index offering high yields, many in excess of 7%. While buying individual shares carries greater risk and requires more due diligence than buying a fund, it is another option in the battle to avoid the corrosive effects of inflation.

Finally, it is important to stress that while cash and bonds form an important part of a balanced portfolio by being “defenders”, and that they can meet short-term income needs, equities are the key piece of the jigsaw to grow wealth in real terms over the long term.