'Sorry, we're cash only!'
There are three primary asset classes: cash, bonds, and equities, each offering distinct risk (measured as volatility)/reward trade-offs. Cash represents the lowest risk and lowest return, bonds are characterized by low risk and low return, while equities pose the highest risk with the potential for the highest returns. Combine these asset classes - et voilà! - you have created a rather crude portfolio.
Until recently, investors have enjoyed a financial landscape defined by accommodative monetary policy which has fostered favourable conditions for growth, propelling the valuations of most assets to record highs. Global markets have ridden along the wave of quantitative easing (QE), low interest rates and a low inflation environment. However, in the past two years or so, this trend has sharply reversed at a pace faster than we have previously witnessed. The Bank of England has raised the interest rate fourteen times in the last two years in order to try and tame inflation.
The impact of the repeated increases to the interest rates on bond and equity markets has been harsh, leading to declines in asset valuations all while elevating the returns on cash investments. However, it's crucial to bear in mind that investing is a long-term endeavour. During challenging times, our natural instincts often drive us toward making extrapolative decisions based on the short-term noise around us. Perhaps the most tempting option in light of the current financial environment is to shift towards cash-based investments that are offering rather attractive returns - as the old adage suggests, "cash is king", right?
Well, not quite…
While cash investments are currently offering higher short-term returns, history suggests equities have much higher potential for long-term returns. Many current investment decisions made by investors revolve around preserving the purchasing power of their assets. However, chasing immediate returns is not an ideal strategy. This is illustrated by research from Barclays (Barclays, 2023, as cited by Ashby, 2023) which examines the historical returns of assets over time and reveals that over the last 123 years, the returns on UK equities (adjusted for inflation) have averaged 4.5% p.a., whereas cash has averaged a modest 0.7% p.a. Hence, if investors aim to shield their portfolios from inflation and achieve capital growth, relying on cash isn’t the best option. While cash may appear resilient against inflation over short periods, in the long term the risk of inflation becomes even more damaging as goods and services become progressively more expensive.
This is further supported by the probability of UK equities outperforming UK cash-based investments. Over any two years (in the last 123 years), UK equities were 70% more likely to outperform cash. Extending this period only increases the probability, reaching 76% over five years and 91% over ten years (Barclays, 2023, as cited by Ashby, 2023).
Markets don’t move in a straight line. Volatility causes returns to fluctuate around their averages, often deviating significantly, making us feel uncomfortable when it works against our favour. Of course, this works both ways too, as it’s easy to mistake a short run of positive performance for skill. Either way, we mustn’t react to short-term volatility as our goals should be centred around making wise long-term decisions rather than surviving a series of short-term periods.
The Randomness of Global Stock Returns:
Source: Dimensional (2023), Which Country Will Outperform
The chart above from Dimensional (2023) shows the annualised returns of global stock markets from highest to lowest by year. The scattered pattern of the table demonstrates the randomness of asset returns and emphasises the difficulty in predicting how assets will perform each year. Perhaps the most important takeaway from the graph above is time in the markets is a far better strategy than trying to time the market, as the risk of getting it wrong is remarkably high. Think of your investments as a bar of soap – handle it too much and watch it disappear. Trying to move from markets to cash could mean locking in temporary losses and thus making them permanent.
The real risk isn’t market volatility but instead, it's from being uninvested and potentially missing out on the next market upswing – as once we see the bandwagon, it's often too late. Uncertainty is the permanent state of markets, it is the reason why investors get rewarded for holding on to equities. By holding on to bonds and equities the interest or dividends will be reinvested at today’s softer prices, which enhances the impact of compounding.
According to Vanguard (2023b), the best and worst days of global markets tend to be in close proximity to each other, so trying to miss the worst days can lead to missing the best days. Having a broad diversification in equities offers a much stronger position for investors to capture a market recovery whenever it occurs compared to moving towards cash. At present, we are already seeing markets positively turn a corner in response to falling inflation data from the UK and the US.
Ultimately, cash investments play an important role in terms of liquidity, but once you have set aside a large enough emergency cash fund to cushion the blows of a downturn, the focus should be on the longer term. This offers the best of both worlds as your emergency fund can still benefit from the attractive rates of cash investments while your portfolio remains invested.
“I’m still not convinced.”
Okay, if this ‘deep-dive’ hasn’t convinced you and you are adamant that moving to cash is still the thing for you, then we recommend speaking to us about money-market funds.
These are collective funds investing in highly liquid, low-risk, cash-based instruments such as treasury bills and certificates of deposit. The main benefit of money market funds over fixed-term deposits is that your money is not locked away and ‘closer’ to markets. However, the main disadvantage of money market funds is there is still an element of risk as their yields tend to move with changes to interest rates.
Lee Nguyen Investment Analyst
References:
Ashby, G. (2023). UK shares: the 70% shot at beating cash. [online] www.schroders.com. Available at: https://www.schroders.com/en-gb/uk/institutional/insights/uk-shares-the-70-shot-at-beating-cash/
Dimensional. (2023). Which Country Will Outperform? Here’s Why It Shouldn’t Matter. [online] Available at:https://www.dimensional.com/us-en/insights/which-country-will-outperform-heres-why-it-shouldnt-matter
Vanguard (2023). Navigating a down market [online] Available at: https://investor.vanguard.com/investor-resources-education/news/navigating-a-down-market
Norton, J. (2023). Vanguard [online] Available at: https://www.vanguardinvestor.co.uk/articles/latest-thoughts/how-it-works/staying-the-course-during-market-uncertainty
This newsletter is intended for information only and does not represent personalised financial advice. If you require advice in respect of your financial planning, you should contact us. Past performance is not a guide to future performance. The value of an investment can fall as well as rise and is not guaranteed – you may get back less than you paid in.