Investors’ problem with cash

As interest rates decline, investors are increasingly being reminded of the enduring problem with cash. As the interest rate paid on savings accounts is cut back by banks to reflect lower central bank interest on their reserves, income from savings also diminishes. The high interest rates from 2022 to June 2024 have allowed investors to avoid confronting the problem, but they are unlikely to be able to do this indefinitely.

The European Central Bank has cut interest rates between June and November 2024, and further cuts are highly likely. The Bank of England has followed suit while the US Federal Reserve lowered interest rates by 0.5% in September 2024, then 0.25% in November, marking its first cut in four years.

While few economists expect interest rates to return to their post-financial crisis lows of zero, savings rates of around 3% to 4% are likely to become increasingly rare, with higher remuneration on protected deposits often viewed as little more than spam in the current economic climate. As central banks lower the interest rates they pay to commercial banks, European institutions have responded by lowering customers’ returns on their saving products.

But investors remain attached to cash and cash-like products. As of the summer of 2024, there were still record inflows into money market funds, for example, which hold cash and short-dated assets such as government bonds. In July, amid ongoing uncertainty about prospects for economic growth and the trajectory of interest rates, money market funds attracted no less than €32.6bn, according to Morningstar. There is a reassuring certainty in knowing that you will get back exactly what you invested which intensifies the appeal of cash savings, especially in a less favourable or more complex economic environment.

Inflation and opportunity cost

However, it isn’t quite true that investors are guaranteed to get back what they put in. There are two key risks with holding large amounts of cash – and the first is inflation. When it is high, your capital may stay the same, but it won’t buy you as much as it did before, and this effect becomes compounded over time. Saving can be viewed as merely postponing consumption to a future date, highlighting the importance of considering purchasing power capacity when evaluating the true value of saved funds over time.

There are two key risks with holding large amounts of cash. The first is inflation and the second is the opportunity cost of holding cash.

Cash savings of €100,000 would have a value of just €61,000 in real terms after 25 years of inflation averaging 2%, the current European Central Bank target. If inflation rose to 3%, the value would drop to €47,800. It is worth noting that eurozone inflation was above 3% between August 2021 and October 2023. While any interest received on your savings would mitigate this loss of value to some extent, in many cases investors would at best break even.

This is where the second risk comes in – the opportunity cost of holding cash. By definition, savings held in cash are not invested in the stock market, bonds or other assets, meaning investors miss out on significant growth potential.

The US S&P 500 equity index has delivered an annualised return of 10.9% for the past 10 years in euro terms (end 2024); an investment of €100,000 would have grown to €295,967. For long-term investors, who need their money to generate the best possible returns to maximise their retirement income, keeping assets in cash means leaving a large amount of potential returns on the table.

In addition, stock market investment tends to provide greater protection against inflation because companies can put up prices in response to their own higher costs. This gives equity investors a built-in advantage.

Nor should investors forget about dividends. They may not be guaranteed in the same way as interest on a savings account, but many listed European companies pay out a proportion of their profit to shareholders. The average dividend yield for companies in the Euro Stoxx 50 index amounts to 2.7% of the price of the shares. That income will in many cases increase over time as companies continue to achieve larger profits. This is a significant defence against erosion in the value of a portfolio caused by inflation.

The illusion of market timing

The other argument in favour of cash is that it can be a useful holding point. If investment markets are looking somewhat turbulent, or depressed, investors can move into cash and jump back into the market when the outlook seems better again. This is a seductive idea in theory, but very difficult to achieve in practice.

Every year, Boston-based financial services market research and consultancy group Dalbar conducts a study that compares the performance of the stock market with the returns of investors in equities. In theory, the two should be identical, but unfortunately investor behaviour almost always gets in the way.

Over the years, the Dalbar study has consistently found that investors typically withdraw their money from the stock market at the wrong time, when share prices are near the lowest point of a downturn. They also tend to invest at the wrong time, when equities are close to their most expensive levels, to the detriment of their long-term returns. In 2023, for example, Dalbar found that the average equity investor earned 5.5% less than the performance of the S&P 500.

Part of the problem is that investing at the bottom means investing when the outlook appears particularly bleak. In 2020, it would have meant investing in the first few months of the Covid-19 pandemic, when many countries had imposed lockdowns that excluded social mixing and much face-to-face business, and there was no prospect of a vaccine in sight.

The most successful strategy is to remain invested through thick and thin, and ignore market volatility, whether up or down.

For investors to take profits at the right time, they should have sold just as the world’s economies were reopening and the world was returning to something like normal. In practice, this is very difficult to do, and humans’ psychological make-up is not geared to this kind of dispassionate, emotionless calculation. The most successful strategy is to remain invested through thick and thin, and ignore market volatility, whether up or down.

Contingency role

Of course, cash still has a place. It is advisable to hold reserves for several months’ spending in cash to protect against life’s ups and downs – redundancy, sickness or costly roof repairs. It is also useful in cases where you may well need the capital for short-term needs.

It can also offer some flexibility. If you are weighing up different investment strategies, for example, it may be worthwhile holding cash while you make up your mind. Equally, if you have just received a significant lump sum, it can make sense to drip-feed it into financial markets rather than placing it all at once. That way you mitigate the risk of investing when markets are near their peak.

Nonetheless, cash cannot form the core of an investment strategy. Holding too much of one’s assets in cash makes it more difficult to achieve longer-term investment goals and build wealth. The goal of investing is to make your money work for you, ultimately aiming for financial independence. While savings should come first, investors need to be alert to the risk of falling savings rates and the impact of inflation on purchasing power capacity.

By definition, savings held in cash are not invested in the stock market, bonds or other assets, which means investors miss out on significant growth potential.