I love questions that start with an apology. “This is probably a stupid question, but…” is always an indication that what follows won’t be.
One such question jumped out at me during a recent Q&A with investors. “If I can get four or five per cent on cash,” I was asked, “isn’t that better than I’m likely to get from any investment today?”
Many people are quite reasonably asking this at the moment.
And they’re right that, for the first time in 15 years, you can indeed now earn what looks like an acceptable return with no risk to your capital.
An instant access account at a bank you’ve heard of might pay you 3.5pc today; you can easily get 4pc if you are prepared to give three or six months’ notice; if you tie your money up for a couple of years, you can expect 4.5pc plus.
These rates are available at a time when there’s a good chance the stock market has lost you money over the past year.
Our best buy fund list has 30 pure equity funds on it (not bonds or alternatives like property, commodities or infrastructure) and in the 12 months to the end of March, 15 of them had delivered a positive and 15 a negative total return (including dividends).
When you consider what happened in financial markets last year, a 50pc hit rate is not bad, but a coin toss between winners and losers does rather strengthen the case for cash.
The real flaw in the question is the assumption that this is an either/or situation.
Like most things, it is not black and white. Other than earning an income, there are at least three good reasons why you should hold some cash in your portfolio – but there are two stronger arguments for not having too much.
The best reason for having some of your money in cash is that it helps you sleep at night.
The conventional thinking about investment is that you should be well diversified, and in recent years that has been a simple case of splitting your money between shares for growth and bonds for stability and income.
Last year dealt a fatal blow to that simplistic model because both equities and fixed income fell in tandem.
This was a particular problem for investors approaching retirement who had been encouraged to ‘de-risk’ their portfolios during the final years of their working life by increasing their allocation to bonds.
In almost all circumstances, this would have been sensible advice.
In a year in which central banks raised interest rates with unprecedented enthusiasm, it wasn’t. When things really go awry there is simply no substitute for cash.
The second reason to have cash in your portfolio is that it allows you to be a better investor.
If you know that you have enough money set aside to cover the day-to-day expenses you expect and an emergency fund for the things you don’t, you will approach your investments with a calm mind.
This is essential. No-one makes good financial decisions when they are in a flap.
You want to have enough money to hand to never, ever have to sell an investment. Knowing you will never be a forced seller will transform your approach to the stock market.
You will start thinking of it like any other marketplace, in which as a buyer you want prices to be low.
No-one celebrates at the fruit and veg stall that tomatoes are more expensive than they have ever been. Why would anyone who is still accumulating a retirement fund think of the stock market any differently?
The third reason to hold cash is that, without it, stock market investing becomes a spectator sport.
If you are fully invested when Mr Market has one of his periodic moments, offering you shares at a discount to their real value, you can’t do much with that opportunity.
You might feel like your cash is doing nothing, sitting on the bench while the rest of your money runs around being busy.
But there is a good reason why successful investors like Warren Buffett wait around for years with billions burning a hole in their pockets.
They are hanging on for what they call in baseball the “fat pitch”, the no-brainer opportunity that comes along only rarely and when everyone else is panicking.
The two reasons for not getting too enthusiastic about cash are really different ways of looking at the same problem.
In both the long and the short runs, there’s a price to pay for the security that cash appears to offer. In the short term, the apparently high headline interest rates available on cash are actually considerably worse in real, inflation-adjusted terms than they were a couple of years ago when interest rates were close to zero.
Because inflation was also low, you weren’t really going backwards in real terms. Today, despite yesterday’s modest fall in the consumer price index, you are.
But it’s over the long run that cash will really let you down. Again, in real, inflation-adjusted terms, the UK stock market has delivered 5.3pc a year since 1900; gilts over the same period have exceeded inflation by just 1.4pc a year; and cash brings up the rear with a real return of just 0.9pc, according to the latest Credit Suisse Investment Returns Yearbook.
The relentless power of compounding means this shortfall adds up over an investing lifetime to an unbridgeable gap. Which is the simple answer to the simple question with which we began.
Source: finance.yahoo.com