Inflation has gathered pace since early 2022 prompting central banks to pivot on interest rates which had sat close to – or even below – zero in the years after the financial crisis.
Ratcheting upwards in quarter point, half point and even three quarter point increments over the past year and more, benchmark rates in both the US and the UK now stand at or around 5 per cent.
While bad news for borrowers on variable terms, it is a welcome shot in the arm for savers and begs the question why would an investor not hold cash risk-free – either as a fixed-term deposit or in a money market fund - and simply collect the interest?
While increasing numbers of investors are rethinking the role of cash in their wider portfolio, it is worth pointing back to the reason that interest rates have risen in the first place, namely inflation.
The best deal in the market may offer interest on cash at or close to the benchmark rate of 5 per cent but if you are UK-based, inflation is running at well over 8 per cent meaning that the real return on cash is negative. And negative returns means losses.
So what should become pertinent for an investor is the consideration of time horizon. For investors with extremely short-term horizons ie, three months or less, there is merit to holding cash for practical purposes as much as any. But for anything longer, historical evidence suggests that equities will always outperform.
While long-term data strongly suggest that equities are more likely to beat inflation than other asset classes, what illustrations often don’t show is the volatility endured along the way.
In approximately half of the past 50 years, stock markets have fallen 10 per cent or more and in a quarter of the past 50 years, the market has fallen by 20 per cent or more.
Returns are consistent over the longer-term, but for shorter-term investors, there is inherent risk attached.
However, it is this very volatility that can jeopardise investors lured by the attractive returns currently offered by cash. Having money locked up for a year or so in a fixed-term deposit means that people’s hands are tied should the market fall and offer an appealing entry point.
If we look back at the past five, 10 and 20 years, savings held in cash by investors have failed to keep up with the rate of inflation.
By contrast, for every 20-year period since the earliest days of stock market investing in 1926, equities have delivered real returns ie, returns that outpace inflation.
While having a cash balance on any portfolio constitutes good management from a liquidity and a hedging point of view, allocating in earnest for any period over three months is likely to leave investors out of pocket when compared with the returns that can be earned on equities.
Cash has been so unattractive in the ultra-low interest rate era that followed the financial crisis that it is understandable that when rising interest rates mean that it starts showing signs of life as an asset class, investors’ interest is duly piqued.
Especially if their equity allocation is at that moment yielding very little and reducing in capital value – the choice can seem like a no-brainer.
However over the medium- and long-term, equities in almost all scenarios provide the greater real return. The emphasis should be on not giving in to the knee-jerk reaction but considering carefully the growth potential of equities within most timeframes.
Hoshang Daroga is investment director at Elston Consulting
