A controversial study has appeared to turn a long-accepted piece of financial wisdom on its head. Is there really a way to make safe cash outperform riskier shares? The answer is, maybe… but that it’s very much a case of horses for courses. Article by Nick Green.
The run-up to the EU referendum saw investment fund managers shovelling assets from equities (stocks & shares) into cash, over fears that Brexit would cause another financial meltdown and send stock markets into freefall. Investment portfolios had cash levels of 5.7 per cent, the highest level since 2001 and a figure usually only seen in a recession. This is because investors tend to flee towards ‘low-risk’ assets such as cash and bonds during times of instability.
Generally, investors who want to see better long-term returns favour higher risk assets such as equities. ‘Risk’ in investment terms means volatility – that is, how likely an asset is likely to rise or fall in value over a given period of time, and by how much it is likely to do so. In other words it’s not a bad thing in itself; investors know that this volatility is needed to lift the value of a portfolio over time – even if the ride is occasionally a bumpy one. You could sum up the investment principle of risk as ‘Fortune favours the brave’.
Cash, on the other hand, is considered a very low-risk asset. Cash investments don’t go down in value (except as a result of inflation), but neither are they known for delivering high rates of growth. But have we underestimated cash?
The amazing moving savings account
A recent study claims to have seen cash beat equities at their own game. Paul Lewis (who presents BBC Radio 4’s Moneybox) claims that through a process of active management, a cash investment can beat equities for as long as 18 years – all without the possible downside that comes with a stock market investment.
The study supposes an individual puts their savings into the best one-year deposit account available, and then at the end of the year (when the high introductory interest rate drops) moves all their savings into the best-buy account available that year, and so on. By continuing to move savings every year into the best accounts on the market, the study concluded it was possible to achieve a steady effective interest rate of 5 per cent.
This performance was compared to a tracker fund following the FTSE 100. In the majority of five-year periods between 1995 and the present, cash savings were shown to outperform the stock market investments – provided they were actively moved every year to the best account available. In fact, Lewis claims that it would be 18 years before equities decisively overtook cash savings managed in this way.
Actively managed savings
Would this approach really work? The main drawback is having to remember to move your money every year – and it’s also questionable as to whether you would always be able to secure the best deal (for instances, some savings accounts require you also to move your current account to that provider, or impose other criteria such as minimum regular deposits).
Practical or not, it’s a good illustration of what a difference you can achieve by actively managing your money. Most providers of savings accounts assume you will take the high introductory rate and then stay with them because it’s convenient, even though the interest rate may then become much less attractive. Certainly it’s more work to keep moving your money around – but then, work is generally a way to make money. If you have a financial adviser who handles your finances on a regular basis, you could discuss making this part of their ongoing service to you (though they may have better ideas).
Why cash vs shares is a case of ‘horses for courses’
So has this study proved that cash can outperform equities? Not quite. Over the longer term equities still came out top – delivering an average 6 per cent after 21 years as compared to 5 per cent for the actively managed cash. What it does demonstrate is that cash is more dependable if you are investing for shorter periods, perhaps less than 10 years and very probably less than five. However, the stock market may still outperform cash over any given period – but the shorter the period, the lower the probability that it will do so.
‘Horses for courses’ is a popular expression among racing fans, who recognise that it can be hard to compare two different racehorses, because some perform better at different distances or on different tracks. A similar principle applies to comparing cash and shares.
When deciding how to invest, you first need to consider your risk tolerance. In simple terms, this is how much money you can afford to lose in the short term, and how long you can wait before achieving positive returns. It defines how much room you have to manoeuvre, and is a key factor in most investment decisions. This is why people who have a lot of money tend to be able to make more money – because they can afford to take on much more risk without affecting their overall lifestyle. It is much harder to chase big investment returns if you are using the housekeeping money.
An actively managed portfolio
If you want to build a portfolio of savings and investments, your risk tolerance will play a big role. For instance, if you have a relatively cautious attitude (hence a low risk tolerance), you may want 80 per cent of your portfolio to be in cash savings, and only 20 per cent to be in equities.
This is where your investments can benefit from another kind of active management. Suppose that your equities perform strongly in a given year. Their value is now higher, so they now make up (let’s say) 25 per cent of your total portfolio, rather than 20 per cent. This means your portfolio is now only 75 per cent cash, and so no longer in line with your risk tolerance.
What you can do then (if you want to maintain the same risk profile) is move the excess growth from the equities into your cash savings, to rebalance the portfolio at 80:20. In this way, your savings have benefited from the growth in the equities. Similarly, if your equities perform poorly for a spell, you may (counterintuitively) wish to transfer more of your cash savings into equities, in order to keep the balance in line with your risk tolerance. In each case you should consult your financial adviser before deciding on a course of action.
It can be tempting to see saving as a largely passive process and investment as a more active one. What the recent cash versus equities study has reminded us is that it’s the degree of personal engagement with your finances that often makes the biggest difference.