Why it pays to think longer-term with your money and not rushing straight to cash

Recently, interest rates have reached a 15-year peak. This may lead to the temptation of reallocating a significant portion of your funds from investments to interest-bearing cash savings vehicles like deposit accounts and cash ISAs.

Rushing to withdraw cash may not be the wisest choice for your finances. In the long run, keeping funds invested in stock market-related assets could yield higher returns. Here are some important factors to take into account.

1. Cash can't keep pace with inflation

Recently, we have all been concerned about inflation. By the end of 2022, prices were increasing by over 11% annually, driven by various factors like the impact of the Ukraine war on energy prices and the ongoing effects of the COVID-19 lockdown.

An 11% inflation rate meant that a weekly grocery shopping bill of £100 a year earlier would now be around £111.

Although inflation has dropped significantly since then, it remains a constant presence. This essentially implies that the purchasing power of the £1 in our pocket is continuously diminishing. Even at the government's targeted inflation rate of 2%, £1,000 would only be able to purchase goods worth £906 after five years and £820 after a decade.

2. Holding a range of asset classes can help optimise and smooth out returns

One more reason to consider beyond cash is that various asset classes tend to excel at different points in time.

The following table illustrates the 12-month performance of major asset classes over a decade. It reveals that stocks were the top performer in three out of ten periods, while commercial property led in four periods. Conversely, low-risk bonds showed strong performance during years when these two asset classes struggled.

This demonstrates that it's not always possible to select the top-performing asset class. Nonetheless, cash has consistently shown the poorest performance overall, as depicted in the performance chart below.

Multi-asset investing can be an effective way to capture strong performance wherever it arises.

Moreover, if you have concerns regarding investment volatility, employing a diversified strategy ensures that any declines in one asset category may be balanced out by increases in another. This can contribute to a more stable performance for your portfolio.

3. Being patient can reap rewards

Naturally, the fluctuations of the stock market may cause you some worry - which is why keeping cash on hand can be quite comforting.

Nevertheless, if you can remain invested for the long term and are open to taking risks, assets such as stocks and real estate have demonstrated the highest appreciation in value over time - refer to the graph.

Past performance should not be considered a reliable indicator of future performance.

That's why it's important to consider how long you can keep your money invested. As a broad rule of thumb, shares can require five to seven years to ride out short-term market falls. If you think you might need to withdraw money sooner - it may be prudent to hold it in lower-risk bonds or, indeed, cash.

How different asset classes have grown 2014-2024

Many investors adopt a 'bucket' strategy for their savings and investments by categorizing their funds into short term (e.g., up to three years), medium term (e.g., 3-5 years), and long-term (e.g., 5-10 years+) segments, and allocating each to suitable assets. Funds can be transferred between buckets based on anticipated usage.

By doing so, individuals can secure a crucial emergency fund (refer to panel) while maximizing the opportunity to outperform inflation and attain investment gains in the long run.

Cash for a rainy day

It may not be wise in the long run to keep all your extra money in cash.

However, it is crucial to have some readily available cash for short-term needs, especially for emergencies like home and car repairs or periods of unemployment.

I typically suggest having a rainy-day fund that covers at least three months' (preferably up to six months') worth of living expenses.

This fund can provide a comforting safety net and reduce the likelihood of having to unexpectedly withdraw money from other investments, such as during market downturns when investment values drop.

4. Savings rates will likely fall at some point

Just like a crystal ball cannot forecast the performance of various investments, it is impossible for anyone to accurately predict the future interest rates on your savings. Even if you are currently receiving a highly attractive rate, it's important to consider the potential rates available when your current rates expire.

To illustrate the frequency and speed of changes in the Bank of England base rate since the early 2000s, we have prepared a chart. If the Bank of England determines that the inflation risk has diminished, it may significantly reduce interest rates.

Again, a properly diversified investment portfolio can help to provide a buffer against that (and, indeed, many investments such as company shares may perform more strongly as lower interest rates benefit their business).

5. Being out of the market can mean missing out

If you are considering keeping the majority of your capital in a deposit account and then transitioning back to investments once interest rates decrease, be aware that attempting to predict the right time to re-enter the investment markets can lead to expenses.

Research indicates that by simply not being present for the top 10 best days in the markets, investors can forfeit a significant portion of their returns. It may be wiser, therefore, to maintain a portion of your capital consistently invested to prevent missing out on periods of exceptional market performance.

The challenge of timing the market

Over the period 30.06.04 to 30.06.24 the annual return for being fully invested is 6.22%, missing the best 10 days reduces it to 5.07%, 20 days is 4.05%, 30 days is 2.97% and 40 days is 1.72%.

In short

While cash deposits are important in investment portfolios and financial planning, there are risks associated with allocating a large amount of capital to cash.

Adopting a well-balanced multi-asset strategy can help you take advantage of potential returns from various sources.

Furthermore, a long-term and diversified approach can help mitigate the volatility of the market.