Are you holding too much cash?

Capital at risk. The value of your investments and the income you receive from them can go up and down, and you may get back less than you invest. Any examples are for illustration purposes only.

UK investors have a habit and it’s worrying the stock market regulator. According to the Financial Conduct Authority (FCA), holding too much cash that could otherwise be invested has the potential to reduce our returns over the long term. And we’re hoarding the stuff.

In 2023, nearly 8.6m consumers held more than £10,000 of investible assets in cash and the FCA is on a mission to reduce that level by 20% by 2025.

While that doesn’t mean every penny we have needs to find its way into the stock market, the point here is we’re not quite getting the balance right. Be it through indecision, lack of confidence in investing, fear or holding out for the right time to jump into stocks, the longer that money sits in cash, the more it’s doing battle with the effects of inflation.

“Whilst consumers now have more options for their cash savings, those with significant excess cash assets, that have some appetite for investment risk and no plan to access their cash in the short to medium term, might benefit from support to do more with their money rather than leave it in cash in the longer-term.”

You risk losing valuable purchasing power as inflation slowly eats into the value of your money. While the pounds and pence in your pocket look the same, what they can actually buy at the shop gets less and less - just have a look at your favourite childhood snacks and how the price of them seems eye-watering nowadays.

Investing has the potential to help your money grow enough to offset the damaging effect of inflation but only if your cash grows faster. There’s no guarantee that your money will do that in the short-term and it may be this lack of surety is putting people off investing. If fear is part of the equation, we need to remember that volatility is the price we pay for the hopeful long-term outperformance of stocks over cash.

Putting the difference in performance between these asset classes in context, from 1900 to the very end of 2023, £1 held in cash would have doubled to £2. If that same £1 had been invested in government bonds it would have doubled again to £4. In stocks, the total return would have resulted in a value of £395. The 123-year ride would have been rockier as we moved along the risk spectrum from cash to bonds, to equities, but the potential reward would have risen as well.

Annualised real returns

When you invest your capital is at risk. Past performance is not a reliable guide to future gains. Source: JPMorgan, 2024. Data as of 31 December 2023. Equities: FTSE 100; Bonds: JPMorgan GBP Government Bond Index; Cash: three-month GBP LIBOR (prior to 2008 cash is short-dated Treasury bills).

This doesn’t mean cash is useless though. For investors, it still has a part to play in a well-diversified portfolio. To help clear things up, let’s look at what cash is good for, when we might want to use it and how much to hold.

1. Using cash to meeting short-term needs

If you’re about to exchange on a house, the last thing you need is to log into your account and see the market has fallen and taken your deposit with it. Make sure your investing monies are geared for the long term and you have a separate cash buffer for upcoming costs that a falling market would put in jeopardy.

2. Keeping cash in an emergency fund

Three to six months is often the guidance but make it more personal than that. You know better than anyone what an unexpected expense like the boiler breaking down would do to your finances. Get ahead of it and set up a cash safety net that you can easily draw from in case of emergency.

3. Adding to cash savings, if the interest rate is good

After an age in the wilderness of low interest rates, cash has got its groove back somewhat as interest rates have risen to tackle inflation. It means the prospect of earning some interest on cash is back on the table. However, you need to make sure the rate you’re getting on your cash is higher than the rate of inflation or you’ll still be losing purchasing power and locking in a loss in real terms.

When it comes to holding cash in your investment portfolio, remember that it is a low-risk asset and can help bring down the overall risk profile of your other holdings like bonds, stocks and commodities. In this sense, despite its low-growth potential, you might still want it for that risk-soothing effect. The trick is to decide for yourself what that amount is, however there’s a difference between actively choosing to hold cash for this reason, and feeling nervous to put it into the assets you really want. Decide ahead of time and stick to creating a portfolio that matches your risk profile and goals.

4. Using cash to buy the dip

Keeping a small amount of cash on the side to take advantage of any market falls is a pretty normal strategy. However, keeping a bit of ‘dry powder’, as they call it, needs to come with some real investment discipline.

Don’t end up sitting on the sidelines forever, waiting for a better chance to jump in. Decide what a good opportunity would look like before it happens. Give yourself strict buy criteria like a company’s valuation hitting a certain level, and stick to it. That will help you make an objective decision when the time comes instead of missing the boat and ending up in cash for longer than you thought. Sometimes investors keep 5% of their portfolio in cash but there’s no rule that you have to - as always, make it personal and decide if you’d rather set up regular investments at defined intervals instead.

5. Using cash as a layover between journeys

Sometimes you can’t help holding cash, like after a stock sale and before the next buy. There’s no harm in taking a breather and cash can be a great asset to allow for that. Just don’t let that short-term pitstop become a long-term cash pile.

It’s good practice to keep tabs on multiple investment ideas so that if one hits the sell criteria there’s another one that can make good use of the cash you end up with. The other side of this coin is to make sure you aren’t just investing in anything because you think you need to put money into the market.

Keep calm, set your criteria and avoid emotion as much as you can. This is really where setting predefined goals and your portfolio’s asset mix become especially valuable. The more you decide now, the less you have to decide when there’s cash burning a hole in your pocket.

Sources:

• FCA: Investing in outcomes: a regulatory approach to deliver for consumers, markets and competitiveness
• FCA: FCA sets out plan to tackle investment harm
• FCA: Consumer Investments Strategy - 2 Year Update
• JPMorgan: Principles for successful long-term investing, 2024.
• Office for National Statistics
• Bank of England

Important information

When you invest your capital is at risk. Past performance is not a reliable guide to future gains. Your investments and the income you receive from them may go down as well as up so you may get back less than you invest.

This article is for educational purposes only. Make sure to do your own research on what investments are right for you before investing or consider seeking expert advice.