In its purest form, cash is defined as the notes and loose change in your pocket. But, in investment terms, cash is an asset class just like stocks and shares, bonds or property
The saying ‘cash is king’ reflects the belief by some that cash is more valuable than any other form of investment. A healthy dose of cash to stabilise investment portfolios is usually a good idea, but understanding the real value – and potential downsides - of holding onto cash is crucial.
Investors who favour a cash cushion may opt to invest in cash through bank accounts or Isas. A current account will usually pay a very low level of interest, while putting it in a cash savings account or Isa for a year or more may attract a slightly higher rate.
With interest rates currently very low, you may find that none of these cash investment options attract a return high enough to beat inflation, effectively reducing the real value of your savings over time.
Inflation, otherwise known as the increase in the cost of living, currently stands at 1.7%. That means the cost of living is climbing at a rate of 1.7%. For each £100 you’ve spent a year ago, the same things will now cost you £101.70.
When it comes to savings and investing in cash, inflation matters. If you’re earning 1% interest on your cash savings but inflation is ticking along at 1.7%, then after a year your £100 will be worth £101, but the cost of what you might buy has gone up at a faster rate.
This is what we mean by a reduction in real value. And while the sums involved in this example may seem insignificant, it can have a ravaging effect on your savings over many years.
Leaving your money invested in cash over the long-term may not be the best option to reaching your financial goals. The Financial Conduct Authority – the UK’s main financial regulator – has already expressed some concerns about this, particularly when it comes to pensions.
Some people at retirement are invested in cash but don’t appear to have any immediate need for the money, meaning its value starts to erode over time.
Of course, none of this means investing in cash is necessarily a bad thing to do. Where you need immediate access to funds and you want to protect the value from falling in the short term, it’s an entirely reasonable option.
It is also recommended that you always have a cash buffer in case of emergencies. Whether it is an unexpected expense or riding out an investment portfolio drop, having extra cash can definitely come in handy at certain times.
The thing to remember is when you invest your money for the long-term, you’re giving it a chance to grow in value. There is no guidebook to tell us how much and when to invest our money. Ultimately, the longer you leave it invested, the better your chances are of seeing it grow and giving you better returns.
On a very small scale, I hold cash investments for my son. I put aside any spare coins I have in my pocket each day, saving them in a piggy bank. The piggy bank earns no interest but given that Arlo is only one year old, he has an extraordinarily long time horizon for his investments.
I’d better get those savings invested somewhere soon or they will definitely lose value. Who knows, perhaps coins won’t even be legal tender by the time he needs them.
Jamie Jenkins is head of global savings policy at Standard Life