Remember When Freddos were only 10p? The risks of holding large sums in cash over the long-term

I recently read a LinkedIn post which stated that 69% of Brits surveyed hold their investable assets in cash, where it earns little or no interest; and that of those surveyed, only 40% have considered investing for the future. Whilst I have no idea where this statistic has originated, assuming the survey was conducted fairly, ethically, and featured an appropriate spread of participants of different ages and backgrounds, and that the 69% kept 100% of investable assets in cash, this statistic genuinely surprised me. (Note – I’m assuming that the majority of people haven’t included their pensions as “investable assets” when taking this survey; I simply don’t believe that 69% of surveyed Brits hold their pensions in cash.)

It is true that for many savers, as was so articulately phrased by someone I respect very much, “For many people, cash equals security. It is a currency they understand and more tangible than investment options”.

I completely agree that many people hold this view. However, this also suggests that many savers don’t fully understand the various risks of holding large sums of cash on deposit over the long term, compared to a diversified investment portfolio put together by a qualified Financial Adviser, which is regularly reviewed, and has been designed to meet the needs, aims, objectives, attitude to risk, capacity for loss, timescale for investment, and tax position of that individual. I’ve listed a number of the risks of undiversified “cash only” investment below, and welcome discussion in this area.

Inflation Risk - “Inflation” is an economic term which broadly means a general increase in prices, and the corresponding fall in the purchasing value of money. A simple example is that if a loaf of bread costs ￡1 in 2017 and inflation is 2% in 2017, the same loaf of bread will cost you ￡1.02 in 2018. It doesn’t seem like much, but if this is compounded over, say, 10 years, your loaf of bread would cost ￡1.22 (more accurately, a price increase of around 21.9%). Meanwhile, if your savings account is only paying 1% interest, your savings have only increased by around 10.5% in the same time period. Simply put: in this example, once inflation is taken into account, you have made a net loss of 1% a year on the value of your cash. Studies have shown that over the long-term, cash returns have failed to outpace inflation, whereas asset-backed investments have.

Liquidity Risk - In general, cash is a liquid investment. Liquidity simply means how easily you can realise an asset in order to spend its value. However, with interest rates at a historical low at the moment, many savers are locking their cash away in fixed-term savings accounts to benefit from a higher interest rate. The terms on these accounts vary, but I’ve seen ones on the market for 1, 3, 5, and 10 years. The longer you lock the money away, the stronger the annual interest rate you can earn. With some of these arrangements, you can access the cash at any time but there are typically early exit penalties in the form of lost interest. However, with others, no withdrawals can be made.

Interest Rate Risk - Continuing from the last point, interest rates can fluctuate. I imagine you’d be fairly gutted if you recently locked your savings away into a 5 year fixed term deal and then there was an interest rate rise – do you take the exit penalty (if you have that option) to reinvest at the new (higher) interest rate, or do you settle for your current (lower) rate of interest? Rising interest rates are normally a reaction to increased inflation. Interest rates are currently at a record low with the base rate 0.25%. The Overnight Index Swap (OIS) rate (speak to your financial adviser for information on OIS rates as the technical details are beyond the scope of this article) on the Bank of England website currently suggests markets are expecting the base rate to rise to around 1.15% in 5 years’ time. As such, how does this make you feel about locking cash away for the long-term from a risk perspective? Another example of interest rate risk is the risk of falling interest rates. Around a year ago (August 2016) the OIS expected an interest rate fall in the short-term. Market expectations of interest rate changes often fluctuate and therefore create uncertainty for savers, who may not realise that by investing all their money in cash they are exposing themselves to a degree of uncertainty as to the future value of their nest egg, and therefore – arguably – are taking a degree of risk.

Reinvestment Risk - This is the risk that you may not be able to reinvest at the same rate of interest as you have previously enjoyed. I’ve spoken to many people recently who have just emerged from 5 year term deposit deals on strong rates of interest who now are unable to reinvest their money into anything which pays anywhere near the rate of interest they’re used to. This can cause havoc if you’d banked on reinvesting at the same rate, for example, if you had a specific target fund in mind for the future, to spend on that life-changing retirement cruise you’d always dreamed of.

Institutional Risk - Sometimes, banks fail. In the UK, savers may be covered by the Financial Services Compensation Scheme (FSCS), which protects cash savings of up to ￡85,000 per person, per firm. However, institutions paying higher rates of interest may be doing so to attract savers as they may not be financially strong, may not be covered by the FSCS, or may be based outside the UK in countries with a weak economy or unstable government. A recent example of this type of risk is the Icelandic banking crisis of 2008-2011, where UK savers seeking higher interest rates deposited large amounts into large Icelandic banks. When the Icelandic economy crashed, the banks defaulted, and hundreds of thousands of UK savers lost ￡billions.

Currency Risk - The term “globalisation” refers to the process of businesses operating more and more on an international scale, and the world economy has never been more globalised than it is today. And one of the key rules of economics is that an asset is only worth what someone else is willing to pay for it. If you have 100% of your portfolio invested in ￡sterling on deposit, and the pound falls against the dollar (for instance) – as it has done significantly since the result of the Brexit vote last year – this makes imports into the UK more expensive, increasing UK inflation and effectively reducing the spending power of your money, not only on imports from abroad, but with increased globalisation, this will also affect the prices of products and services produced in the UK as well, as UK manufacturers’ costs of importing raw materials increase. Alternatively, a diversified investment portfolio can help reduce this risk by investing across a range of different economies using different currencies.

Political Risk and Taxation - Tax rules change from year to year, and it’s important to remember that entering into an investment purely for tax reasons is generally considered poor financial planning. The taxation of savings and investments is a complex area and beyond the scope of this article. But if we take a higher-rate taxpaying saver with a portfolio of ￡500,000 in cash paying 1% interest a year, this is ￡5,000 interest. The tax due will be ￡1,800, which is arguably very significant, and means there’s less in the account to bring forward into future years to compound and produce higher returns. There are other investments which, for many savers, may be more tax efficient. For many investors with ￡500,000, it is likely that a range of different “tax wrappers” could prove useful and help diversify the risk of a change in fiscal policy.

In conclusion, if you are sitting on large amounts of cash that you don’t need to access in full for at least five years, I urge you to speak to a suitably qualified Financial Adviser… I am one, but you can also go to www.unbiased.co.uk to find one. Advisers can explain the various risks associated with different types of investment (including cash) and discuss putting together a suitable portfolio structured to meet your needs, aims, objectives, timescale for investment, attitude to risk, capacity for loss, and tax position; diversified across numerous asset classes such as cash, fixed interest securities, property, equities, and alternatives such as commodities, private equity, infrastructure, and hedge funds. And then further diversified across different institutions, countries, sectors, and economies, which studies have shown spread and minimise specific types of risk. Many advisers offer initial consultations or meetings at no cost, so it can be hugely beneficial to speak to a professional about this.