Why staying in cash carries risks

Look back to the year 2000, and you might understand why so many people are hesitant to put their hard-earned money in the stock market. Many investors have been hurt more than once by investing in equities, and they are having a hard time believing that it won’t happen again. The FTSE 100 was down 6.5 per cent in 2000 and 14.7 per cent in 2001. For 2002, the Index dropped another 23.4 per cent. Over that three-year period, stocks declined by almost 45 per cent. Anyone who owned equities during that period of time saw the value of their investments take a significant tumble. After a few years of recovery, the same thing happened again in 2008. In 2008, the FTSE 100 was down 30.9 per cent.

Although owning equities over the long term has proven to be a sound strategy for earning a higher annual rate of return than almost any other type of investment, people have become scared, and a substantial number of them are staying in cash. While it is smart to be cautious before you invest, being too cautious can wind up costing you more than you might imagine.

As any astute investor knows, there will be times when it is smart to be fully invested in the stock market and other times when it is prudent to have more of your resources in cash or cash equivalents.

You might want to start lightening up on equities if you believe the stock market is due for a correction. Typically, when the broad market has been rising for a number of years and is at or near historical highs, there is a good chance that stocks will start to decline. You have to look at the charts and fundamental data to decide how much room there is to the upside compared to the downside risk.

You might want to hold more cash if you will need to use that cash in the near future. If you are planning to buy a house, you don’t want to have to sell at an inopportune time to raise the money you need to purchase the house. Similarly, if you need money to send your child to college, or for any immediate need, cash is what you need.

In order to be prepared for emergencies or other unexpected expenses, you should set aside anywhere from three to six months of income in an easily accessible account. While you won’t earn much interest in a savings or money-market account, you can withdraw any or all of your balance at any time without penalty.

One more reason to carry a high cash balance is so you will have funds available so you can act on a good investment opportunity. If you are fully invested, you might not have additional funds to take advantage of a good buying opportunity.

While market conditions, plans to buy a house or having cash on hand for emergencies and unexpected expenses, are reasons to hold cash, they are short-term reasons. When you are investing for the long-term, you should only have a small portion of your entire portfolio in cash.

If you want to build wealth over the long term, staying in cash is perhaps the worst thing you can do. If you lock £20,000 away in a safe today and retrieve it in 10 years, you will still have £20,000. However, assuming that there will be some inflation over those 10 years, you will lose purchasing power. If you put it in a safe savings account, at today’s interest rates, you will still probably not be able to keep up with inflation.

Probably more important than the decline in purchasing power is the opportunity you give up for growth and better returns on your money. Investments range from very safe fixed-rate bonds that earn a higher interest rate than saving accounts to equities with more risk and potentially greater rewards. Money that is just sitting does not generate any income and will never grow in value.

If you don’t want too much money in the stock market, add balance with property, fine art, rare coins, and almost any other asset class will give you better returns than cash. It is fine to be cautious, however, a good financial adviser would typically recommend not to hoard all your cash.

As ever when it comes to personal finance, the best way to meet your individual objectives is to devise, implement, and actively manage a sound strategy with an independent financial adviser.

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