At times like these, is cash 'King'? Or is that just an illusion?
With interest rates having risen to 5% for the first time since September 2008, investors are understandably questioning whether the additional risk of investing in markets is worthwhile given the rates available on cash. In this article, John Genovese, our Investment Team Manager, looks at the case for investing in cash deposits.
The main attractiveness of holding cash - whether it be in a bank, building society or National Savings - lies in the perception that future returns are more reliable than investing in markets. However, the reality is that returns on cash are only reliable in the very short term. Over longer periods the interest paid on cash is actually a lot more volatile than one might expect.
To illustrate this point, the chart below shows the dividend yield on UK equities (in other words, the amount of income paid to an investor in shares) relative to the interest rate payable on cash in the UK since 1899. The lowest equity dividend yield was 2.0% and the highest was 6.9% (ignoring the anomalous spike to 11.7% in 1973). More importantly, the equity dividend yield has been far more stable and consistent than the rate of interest paid on cash over time.
This makes sense when you consider the drivers behind changes to interest rates and those which dictate the level of dividends paid by listed companies. Increases in interest rates by central authorities is typically a very unpopular move, given the negative impact it has on public finances through higher borrowing costs and often the valuation of most people’s biggest asset, their home. Conversely, dividends paid by listed companies are reflective of how successful and profitable they are, which provides a strong disincentive to business owners and managers to cutting dividends and a strong incentive for maintaining or increasing them over time.
It may surprise you to learn that the average equity dividend yield and interest rate paid on cash over the last 123 years are identical at 4.5%. Of course, the difference with equities is that there is also the chance for capital growth in addition to the income paid through regular dividends. This means that the yield, expressed as a percentage of the value of equities, tends to rise over time whereas the interest amounts received on cash are more static.
As shown in the table below, this has meant that UK equities have achieved an annualised total return (dividends + capital growth) of 8.8% p.a. over the last 123 years, compared to just 4.5% for cash. When you then factor in the impact of compounding that higher level of returns over time, the difference in the value of invested capital when investing in equities vs cash is very significant indeed.
Investment into financial assets is effectively a contract between the investor and a company or government. To make this worthwhile, the company or government needs to offer investors the prospect of better returns on their investment than could be obtained by investing in cash. This excess return over the interest payable on cash is called the ‘risk premium’ and it represents the potential additional return available to compensate investors for taking on additional risk.
The chart below shows the average long-term annualised returns of equities, high yield corporate bonds, investment grade corporate bonds and government bonds in the US relative to returns on cash. All asset classes provided investors with excess returns above those available on cash, with the level of excess returns reflecting the additional level of risk inherent in that asset class.
This begs the question, if returns on cash can’t beat the returns available on the lowest risk investment in markets, why hold it? The answer in a longer-term investment context is liquidity, optionality and diversification, not returns, and ultimately returns is what investors need if they are to achieve their personal and financial goals.
Many investors are acutely aware of the dynamics described in this note, which suggest that remaining invested in markets for the longer-term, come what may, is objectively the best course of action. So why is it that at the worst possible time to do so, some investors consider selling their investments when they are undervalued with a view to holding cash instead?
Battling Your Amygdala
The answer is human nature, or to be more specific, the part of the human brain called the amygdala. This is used to store our experiences to memory, it’s like a save button on a computer. We actually all have two amygdala, one on each side of the brain. The one found in the left hemisphere of the brain deals with both positive and negative events, but the one on the right hemisphere only processes negative events.
This imbalance means that positive events are only recorded by half of the brain and we end up needing three times more 'good' things to happen to us than bad, just to perceive things as neutral.
Whilst this might seem a little unfair, this inherent negativity bias keeps us cautious, which has been a useful trait for most of human existence as we sought to protect ourselves from the elements, predators, and each other over the course of our existence on this planet.
The problem we all have in the 21st century is that most of the things which used to threaten us and which our brains are wired to protect us against, are no longer as life-threatening as they once were. This leads our brains to seek out other things to worry about, and the world of finance is the perfect playground as there is always something to worry about and always a commentator predicting an impending disaster.
One way to address this imbalance is simply to look less often at markets and related news stories. Left to their own devices and without a proper plan, people are inclined to check what’s going on in their portfolio on a regular basis, sometimes even daily. This is particularly prevalent when there is a lot of bad news in the world, as there has been in recent times due to the pandemic and war in Ukraine.
If you checked the market (global equities in this example) every day from 1990 to present day, you would have seen it rise on 54% of those days and fall on 46% of those days. Given the negative bias driven by our amygdala, this daily routine is likely to lead to a negative view of investing in markets. This is despite the fact that remaining invested in markets has returned more than +700% over that time.
Ignore the Noise
However, if you decided to ignore the short-term noise and only check in on market returns on a quarterly, semi-annual or annual basis, the picture is very different. Checking market returns once a year from 1990 to the present day would have resulted in you seeing a positive return 70% of the time and a negative return only 30% of the time. Checking on a quarterly basis over that time would have resulted in 67% showing a positive return and 33% negative, which is almost as good.
Our Financial Planning proposition is purpose-built to take on the daily worries and stress that come with all things finance-related, so you don’t have to. This frees up time and energy which can be used to live your life ‘on-purpose’, in line with your values, and to enable you to achieve your personal goals. Our regular Progress Meetings, which are held on an annual or semi-annual basis, provide an opportunity to review your investment strategy in the context of your Financial Plan and ensure you remain on-track to achieve your goals.
This frequency of review is also perfect for managing the psychology of investing, taking into account our inherent negativity bias. History suggests that monitoring markets any more frequently is unlikely to lead to a positive mindset. Furthermore, it doesn’t change the outcome, the fact of the matter is that remaining invested is empirically proven to be the best strategy and the biggest detriment to returns is the investor themselves taking inappropriate actions at the wrong time driven by emotional responses to events.
To illustrate this point, if you take the annualised returns of US Equities (S&P 500 Index) from 1990 to 2021 and then adjust them to assume you disinvested for a period and missed some of the best daily market returns, the results are staggering. Missing just the three best days of returns reduced your annualised return from 9.9% p.a. to just 0.3% p.a. Missing the five best days or more resulted in you losing money.
To make matters worse, around 70% of the best days occur within fifteen days of the ten worst days. So, if you are watching markets daily and react to the worst days by disinvesting, the likelihood is that you may miss out on the best days of market returns which come within a matter of days or weeks later.
Numerous studies have been conducted over the years and the conclusion is always the same - the highest probability of success comes from remaining invested, diversifying and letting it compound over time. That remains our advice, and it's a message that you will continue to hear from your own Financial Planner.
John Genovese DipPFS, EFA™, CertPFS (DM & Securities)
Investment Team Manager