Cash investing friend or foe?

Deciding whether to hold cash or invest in the stock market can be a difficult choice that is typically driven by a risk averse attitude and a more limited capacity for loss. However, any decision to invest in cash can come with serious consequences for long-term growth potential.

Investing in cash can often be a result of investors excessively focusing on short-term economic news, poor company earnings, or disinvesting with the herd if markets suffer a correction. This focus is often at the expense of company fundamentals and long-term value creation.

Cash investments may make sense if investors are worried about heavy market drawdowns and recessions, but investors should also be aware that inflation eats away at the real value of money.

This is why stagflationary environments (persistent high inflation combined with stagnant economic activity) can be very difficult times, not only for investing profitably, but also for the preservation of capital and wealth. So is cash investing a ‘friend or foe’?

Inflation And Cash Investing

With the cost of living increasing across the board globally, essentials like food, fuel and energy are experiencing some of the biggest increases, hurting the bottom line of many households.

As a result some investors are looking at a defensive cash investing position, but even though the nominal value of cash and investments will not go down if you hold cash, due to increases in the cost of living over the last ten years, inflation has eaten away at the purchasing power of cash over time. For that reason, and the low yields of cash assets, cash has steadily lost real value in terms of its purchasing power over the long-term.

Whereas it can be argued that the last decade has, for the most part, been unusual due to the ultra-low rates policy of central banks globally, it is also true that, until 2021, this was accompanied by a milder inflation environment, although not low enough to prevent negative real cash yields (after inflation).

If we look at the very long-term data series from the Office of National Statistics, using the Retail Price Index, and the historical base rates of the Bank of England, the average annual compounded inflation has been 4.2% since 1900, and 5.2% in the post-WWII period, to September 2022, which implies a significant dent to cash returns once inflation is taken into account.

Some investors use cash in a way that can detract from their ability to reach their long-term investment goals, either by holding onto it for too long, which can limit the potential return on their savings and investments, or by using it when the market feels risky, which can cause them to miss out on market-recovery opportunities and some of the best available returns.

Short-Term Pressure vs Long-Term Results

Short-term cash investing can make sense if investors manage to time it perfectly and markets subsequently fall, but investors must also be ready to commit their capital back into the market at the gloomiest of times to take part in market recoveries. It is a lot to get right!

Holding cash comes with an inflation cost and, as time goes by, it also exacts a potentially far larger opportunity cost – this is the cost of missing out on gains that investors would otherwise have enjoyed if they had stayed invested in risk assets.

History shows us that long-term investing in global equities and global bonds has outperformed cash, as seen in the chart opposite. The trade-off for taking risks with your money in the stock market is the potential to earn a higher rate of return than cash.

Whereas the volatility of fixed income and equity markets can lead to periods of underperformance, the risk premia embedded in those assets enables investors to capitalise on their staying power. These asset classes have tended to generate real returns (in excess of inflation) in a more meaningful way, with more frequency than cash, if the investment is held for a long enough period.

Diversification and Spreading Risk

Remember the old saying, ‘don’t put all your eggs in one basket’. Diversification can help investors manage and spread risk!

Diversification means making sure investors are not relying on one type of investment too heavily. This can help protect investments, reduce volatility, and lessen the impact of any one asset class performing badly, but won’t eradicate risk entirely.

Some common mistakes investors often inadvertently make are failing to set up a long-term plan, allowing emotion and fear to influence decisions, not diversifying their portfolio correctly to meet their risk appetite, and putting their money in multiple funds that hold basically the same asset.

One approach to consider could be using a risk profiled, globally diversified, multi-asset fund. Embark Investments multi-asset globally diversified approach seeks to take advantage of different market conditions through dynamic active management, aiming to deliver returns in line with the investors risk profile over the medium to long-term (5 or more years).

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