Thinkpiece

03 Jul Thinkpiece

In this update: 

• The impact of holding cash over the long-term.
• The true role of cash.
• The impact of inflation on cash.
• Creating the right balance.

In times of economic uncertainty or fluctuating market conditions, it is entirely natural to look at a healthy cash bank balance and feel a sense of security. Cash is tangible, static, and seemingly immune to the drops occasionally seen in the stock market. However, for savers, an over-abundance of cash presents a quiet, insidious hazard.

As Independent Financial Advisers, when we create a financial plan or review an existing one, we will look to determine the appropriate amount of cash to hold for the given circumstances.

A cash holding can provide a liquidity cushion, which is an essential contributor to the plan, but it must be kept in proportion. Holding higher than appropriate levels of capital in cash savings over long time horizons can severely derail your long-term standard of living.

Unfortunately, by the time you realise this, it could be too late.

Today people who hold cash equivalents feel secure. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value.

Warren Buffett (from his 2011 letter to Shareholders)

The True Role of Cash – Accessibility, not growth

To establish a healthy relationship with liquidity, we must remember a fundamental rule of wealth management – Cash is there to be available, NOT to make you money.

Think of your cash account as an insurance policy, not a driver of investment growth. It serves two distinct and vital purposes in your financial plan:

• Emergency Reserves – Typically anything between 3 and 24 months of essential living expenses could be kept accessible to absorb unforeseen shocks like structural home repairs or temporary income loss.
  By accessible, I don’t mean a 3-year cash ISA bond. That isn’t accessible and you will likely receive a penalty if you do access the funds before the fixed term is out.

• Earmarked Capital – Funds allocated for known, short-term expenditures occurring within the next two to five years — such as a planned property purchase, a change of car, or a tax liability should be earmarked as such and not included in any long-term investment plan or any short term emergency fund.

Once those two buckets are at the required level, any cash surplus is no longer protecting you – it is actively working against you.

The Silent Thief – Long-Term Inflation

The primary danger of surplus cash is inflation. While a bank balance of £50,000 will still read £50,000 on your statement in ten years’ time, its real-world purchasing power, what that money can actually buy, will have fundamentally shrunk.

Look for yourself at the Bank of England’s inflation calculator – https://www.bankofengland.co.uk/monetary-policy/inflation/inflation-calculator

Even if inflation sits perfectly at the Bank of England’s modest target of 2%, the compounding impact over a decade or two is considerable.

The chart below illustrates exactly how the real value of stagnant cash decays over time.

Source: Internal financial modelling.

Deploying the Remainder – Two Smarter Choices

If you possess cash above your emergency and earmarked requirements, financial planning principles dictate that this capital should be redirected. Broadly speaking, you have two highly effective routes:

• Repaying Debt – Clearing liabilities is the equivalent of securing a guaranteed, tax-free return equal to the interest rate of the debt. Paying down a 6% mortgage or a 10% personal loan outpaces almost any reliable savings vehicle available.
• Investing for Real Capital Growth – For capital you do not intend to touch for five years or longer, moving up the risk spectrum into a diversified portfolio of global equities, bonds, and real assets via tax-efficient wrappers is historical reality’s best defence against inflation (the timing of which is not guaranteed – and subject to advice). Over multi-decade timelines, the stock market has consistently outperformed inflation, preserving and growing generational purchasing power.

Striking Your Right Balance

Determining exactly where your cash safety line sits requires careful analysis. Stripping your liquidity too bare can force you to liquidate investments at an inopportune moment in the market cycle. Conversely, hoarding cash ensures your hard-earned wealth slowly melts away.

Our role as advisers is to help you draw that line clearly, ensuring that your finances serve you well within the dynamic structure.

The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislatures. The inflation tax has a fantastic ability to simply consume capital.

Warren Buffett

Your opportunity

If you’ve not yet put in place a sound financial plan and you’d like to know more, please feel free to contact us on 01626 305318 or via email here.

The value of investments can go down as well as up. You may end up with less back than you have paid in. Past performance is no guarantee of future returns.

The views expressed are not to be taken as financial advice. Professional advice should be sought before proceeding.

This post is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations.

Information herein is believed to be reliable but Stover Financial Planners Ltd does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any regulatory duty that Stover Financial Planners Ltd has.