Navigating today’s low interest rate environment

• Cash has always carried a price in the form of opportunity cost - potentially foregoing strong capital market returns with cash that is surplus to short term needs.
• The real risk to long horizon investors is loss of purchasing power due to inflation and cash has a significant exposure to this cost.

There are myriad reasons why investors hold cash.  Unquestionably, however, often a considerable portion of uninvested cash is not needed to meet short-term spending requirements.  The risk of not meeting your financial goals rises in proportion to the levels of uninvested surplus cash that is held as the cost of long-term needs increase over time.

This article aims to highlight the explicit and implicit costs to holding unnecessarily high levels of cash in today’s low interest rate environment, and how you could potentially allocate and structure your wealth to help meet your long-term objectives.

Confusing certainty for security

The impulse to protect what we have is instinctive in us all.  This applies to all manner of possessions, not least our wealth.  The recent decision by banks to further lower interest rates for cash on deposit has understandably struck a chord.

All investors should have immediate liquidity requirements addressed as part of their financial plan, meaning there are legitimate reasons for holding cash in a portfolio.  However, to the extent that the amount of cash held goes beyond requirements for short term expenses, the reasons provided are generally a variant on a constant ‘safety’ or ‘peace of mind’ theme.  This is, however, confusing certainty for security.

• Does cash provide certainty? Unequivocally yes.  We are certain about the direction of deposit interest rates and that cash holdings will be negatively impacted.
• Does cash provide security? Unequivocally no.  The certainty of cash does not provide security against the real risk that investors face, which is the value of savings – the primary threat to which is inflation.

Defining risk as loss of purchasing power

We tend to think about money in nominal terms – pounds and pence in our bank account.  In the long run, the only rational definition of money is purchasing power.  If my living costs double and my capital and interest thereon remain the same, I have effectively lost half my money.  If money is purchasing power, risk becomes that which threatens it and security, that which preserves or enhances it.

This is the critical issue.  We have grown up with the idea (misguided) that the primary risk of investing is the variability of our capital over short time horizons.  Defined as such, then cash does seem low risk.  Afterall, even with negative interest rates we can be certain of what the value of a deposit will be six or twelve months from now.

Defining risk, not as volatility, but as loss of purchasing power, changes the investment landscape completely.  What is traditionally defined as low risk (cash and government bonds), becomes high risk in this context (as they have historically provided minimal security from inflation).  The assets that have protected us from long term real losses (equities and property), become low risk.

This has implications for any investor holding cash in excess of their short-term requirements. 

Macro environment and the cost of holding cash

According to Davy economic research analyst Colin Grant “Real estate was the most dangerous asset to be overweight in the last cycle, and cash is now a dangerous asset to be overweight given the growth in money supply and scale of currency devaluation.”

There has never been an explicit cost for holding cash, which for many investors is a default decision.  It’s very obvious that with extremely low interest rates, that decision (and it is a decision) to hold cash in excess of liquidity requirements, is going to attract an explicit cost in terms of negative real rates (the impact of which is shown below).  Interest rate expectations are exceptionally well anchored, and no material increases are expected for several years.

Arguably a more material cost to holding excess cash is the impact from inflation and the opportunity cost of not being invested in less liquidity constrained objectives, today, during an individual’s lifetime and for generations to come.  The chart below depicts the opportunity cost using a balanced portfolio.  Breaking down asset classes, the long-term real returns using the Barclays Equity Gilt Study 2018 (covering 118 years), for UK equities, bonds and cash are 5.1%, 1.3% and 0.7% respectively.

Figure 1: Projection of cash, inflation and long-term diversified portfolio over next 10 years

Source: Davy and Bloomberg.  Projections based on projected inflation of 2% per annum, estimated net return of 4% per annum on a diversified portfolio, interest rates as per market expectations (Sonia forward rates) as at 9 November 2020.

Inflation

A savvy observer will note that inflation in the UK over the last decade has been relatively muted, so has posed little real cost to cash deposits.  Quiescent headline inflation numbers however mask strongly rising underlying price trends.  Inflation in healthcare, insurance, education and leisure is much higher than headline inflation numbers would suggest.  Depending on what is in your average consumption basket, your personal inflation rate could be very different to what is captured in headline inflation numbers.

What implications does this have for investment strategy and returns?

The classic investment view of cash is that it’s something to avoid, or at least minimise.  To the extent cash is truly needed for immediate or near-term liquidity, holding some is a necessity.

From a behavioural standpoint, reports find that maintaining a healthy level of cash-on-hand appears to improve our feelings of financial well-being and life satisfaction.  Rather than view cash holdings in excess of requirements as an investment mistake, to the extent that it is satisfying some current assets requirement, we would ask the question, are there liquid alternatives that achieve the same emotional ends without the associated cost?

Historically government bonds have generated a decent long-term stream of returns that was typically uncorrelated with equities and property, i.e. they provided good diversification in a balanced portfolio.  Today, a UK 10-year government bond (Gilt) yields only 0.17%.  With negligible cash rates, and an ever-present inflation risk, the goal for investors of maintaining the real value of savings necessitates a more active approach to decision making than was historically necessary.

As such, government bonds and cash can no longer be relied upon to the same extent as they were historically, to meet long term financial goals.  

Wealth allocation framework: How to allocate your wealth

Investing is a deeply personal undertaking.  A wealth allocation framework helps you to ‘begin with the end in mind’, empowering you to take a step back to consider and set financial goals and to understand the trade-offs you need to make in order to achieve them.  In particular, the framework will help you understand how you can better align your portfolio (including your cash balance) with your objectives so you have what you need today, throughout your lifetime and during the lifetime of your family.

Step 1: Start with you

The first and most important step is to understand what your unique financial goals are and the resources available to achieve them. Essentially, you begin by considering what success really looks like in your life taking into account your personal needs, risk tolerance and future aspirations. An example of a goal includes maintaining your standard of living in retirement. Some financial goals are more important than others to you and prioritising is a key part of this first step.

Step 2: Goals segmentation

Once all the information is collated, the building blocks of a plan can be assembled. This approach involves segmenting your goals around the key aspects of your life – taking account of your needs, your wants and your aspirations.

Step 3: Structuring and investments

Now you have a clear picture of what you want and when you want it, the next part of the plan is to ensure you have suitable structures and a suitable investment approach in place to achieve this. This involves understanding and implementing the correct structures to achieve your objectives most efficiently.  For example, this may involve a retirement account so you can save for retirement on a tax efficient basis.

The suite of investment solutions is designed, considering all the variables (inflation, volatility, time horizon etc), with a view to maximising the outcome at each risk level.

The Davy Core strategy is designed and sized to include all the assets and resources the investor plans to utilise for the remainder of their lifetimes.  At the lower end of the risk spectrum we combine bonds with a modest allocation to return seeking assets (equities and alternatives), managing downside risk but with an eye on inflation as the return hurdle.

At the higher end of the risk spectrum, the allocation to equities and alternatives provides a greater potential for return, with the acceptance of greater risk of potential downside.  For long horizon investors, the greater the allocation to equities and alternatives, the greater the chance that inflation plus returns will be realised.

Step 4: Monitoring and reporting

Throughout your personal planning led approach, you will meet regularly with your adviser to assess progress of your portfolio against your goals, essentially carrying out health checks to ensure you remain on course for success.  Indeed, as your circumstances may change, this dynamic approach enables your portfolio and structures to be revised accordingly to adjust to the new circumstances in a consistent manner.

How can Davy help?

As stated previously, there are myriad reasons why investors hold cash.  Depending upon the reason(s), the appropriate action (if any) will differ.

To the extent that you can accommodate more limited liquidity or modest drawdown risk, Davy has devised several investment solutions as part of its wealth allocation framework.

At its core, the wealth framework approach that Davy recommends is a blueprint for investors who want to understand how they can better allocate all their assets and manage their liabilities to help meet their objectives. It is designed to provide clarity for all financial decisions embedded in your specific goals and objectives.