But despite our tendency to favour the status quo, it makes sense to put your money to work. We outline the reasons why below and we also illustrate sensible and efficient ways to move from holding cash to being invested.
Why you should consider moving out of cash
With interest rates at such low levels it’s very hard to get decent levels of return from cash. On the other hand, markets can often be volatile, with good and bad years, so it’s easy to see the appeal of the perceived certainty of cash. Except that certainty is a fractured safety net, due to the persistent impact of inflation. While inflation is low enough now it can meaningfully erode the real value of your capital in the long run, as the chart below illustrates.
Inflation erodes the real value of your cash in the long run
Source: Netwealth & Bloomberg. The values represent £250,000 invested in 1 month Libor and an example Netwealth Risk Level 4 portfolio minus UK CPI.
Simulated past performance is not a reliable guide to future performance.
This is why you need to think about investing to maintain the real purchasing power of your money.
How much cash should you hold?
It’s helpful to think of our assets as being part of three pots, with each one being apportioned according to your own specific needs.
Three Pot Theory™
Because pot one is for your day-to-day spending, this money needs to be accessible and should be your main cash component of your funds. Rather than having a pension with a sizeable cash component (and therefore not working very hard), it is better to have it here where you can use it if you need it.
Pot three on the other hand, contains less liquid holdings such as property, single stocks or passion investments such as wine or cars. Pot two is where you should concentrate your long-term investments, such as your pension or money you don’t need in a hurry but can still access if need be.
So the question of how much cash you should hold can be answered by contemplating pot one – and your specific circumstances such as what stage you are at in life. When you are younger you may need cash for a home deposit, if you are older you may need the security of cash to cover unforeseen medical bills. Your cash needs fluctuate over time.
What do you want to achieve?
The goals you want to achieve in life will help you define the nature of your investment strategy and what assets (such as equities, bonds and cash) to hold, and for how long. For example, if your main aim is to have a secure retirement in 30 years, then you may choose a higher risk level to help you reach the returns required for your long-term goals.
Your time horizons help to define what assets you should choose, but also how much risk you might be comfortable taking. Again, if you have a longer time horizon, you may choose a higher risk level to give your assets time to recover in the event of a downturn, which they typically do. If you need access to funds quicker – for a child’s education, for example – you may prefer a medium or lower risk level.
Potential obstacles to successful investing
A medium to longer term outlook positions you to benefit from the fact that stock markets generally go up over time. Yet this attribute will only reward you if you stay invested. For example, if an investor had missed the ten best days of each decade since 1930, according to S&P and BofA Global Research in 2020, their return would have been 91% versus 14,962% (including ten best days). This highlights the danger of trying to second guess the market.
Active fund management has its challenges, too. The chance of an active manager consistently outperforming the market is very low, even in a downturn. An analysis by S&P Dow Jones Indices in 2020 showed that 89% of active large-cap funds underperformed the S&P 500 over 10 years1. Picking the active managers who can outperform is notoriously difficult, and consistency of fund outperformance after costs and fees is rare.
You may also be tempted to wait for markets to pull back enough before you invest. Yet a sizeable reversal happens much less than you may think (only three times since 1994). And the consequence of sitting on the side-lines – and waiting for the ideal opportunity – can result in you missing out on significant potential gains over time.
This is particularly true if you are not planning to invest into the index that you are monitoring for a pullback. As you see with our Risk Level 5 portfolio below, the pullbacks that occur in equity markets are not always felt to the same degree within a diversified portfolio.
The top line is the cumulative return of the portfolio, while the bottom line shows the pullbacks, which have little overall effect on the long-term upward trajectory of returns.
Market pullbacks happen less often than you might think
Source: Netwealth/Bloomberg
Simulated historic returns are based on current strategic allocations, looking back over the last 25 years of historical asset class index returns and an estimate of costs and charges associated with investing.
Simulated past performance is not a reliable guide to future performance.
Two ways to effectively move into investing
1. Staggering
Staggering is one effective strategy to help you move from cash into investing. While markets in general go up, if they are falling you can still gain valuable market exposure even if you don’t want to put everything in. This example below – highlighting the negative period after the global financial crisis – shows how someone could use multiple entry points to somewhat protect them when planning to invest £1m.
Staggering can help protect you against falling markets
Simulated past performance is not a reliable guide to future performance.
As you can see, they could have invested everything straight away, stagger their money in over five months, or over 10 months – with different outcomes for each at the end of the period. The benefit of staggering in this case is that they faced less losses over a 10-month timeframe, but in rising markets being fully invested from the start would be a better option.
You can also observe below how regular savings added to your investment portfolio over time can potentially let you buy assets at a lower price during volatile periods. With pound cost averaging you can consistently build up your investment pot, while not having to worry about investing a lump sum before the market falls and experience the stress of an immediate decline in value.
Regular savings build up over time and will allow you to pound cost average into markets
Source: Netwealth/Bloomberg. Assumes £100k invested initially in RL 5 SAA and an additional £5k per month.
Simulated historic returns are based on current strategic allocations, looking back over the last 25 years of historical asset class index returns and an estimate of costs and charges associated with investing.
Simulated past performance is not indicative of future performance.
2. Blending risk levels
Investors may also choose a blend of different portfolios with different risk levels depending on when they might need their money. For example, you may need the security of a consistent income for the next 10 years, so a low risk portfolio may be appropriate for this purpose.
At the same time, you may want to withdraw money in 15 years for a different objective, so you might invest another portion of your overall funds at a medium to higher risk level. You may also be planning an inheritance for your children, which you won’t need yourself, so this might be invested in a higher risk portfolio again.
A blend of different risk portfolios gives you many options for managing your future capital needs. The exact amounts and precise risk levels depend on your specific needs, but there is no reason for your overall pot to reside in a low-risk portfolio – and not potentially benefit from higher equity growth – if you can time the pace of withdrawals.
Make more of your money
Due to the impact of inflation, the case for investing over the long term is irrefutable. Yet you also have the freedom to invest for shorter time periods, to invest flexibly and to choose different levels of risk for different parts of your overall portfolio.
Your specific needs and goals will help you to define an investment strategy that suits you best. You can talk to us at any time, and we will help you to find a balance that is both comfortable and helps you to meet your objectives.
If you would like to discuss – at no cost – how to move from cash to being invested please book an appointment at a time convenient for you here.
Please note, the value of your investments can go down as well as up. Our advisers offer restricted advice that relates to Netwealth’s products and services and does not consider the whole market. Netwealth does not provide tax or legal advice and does not advise on transfers of pensions with safeguarded benefits.
1 Source: S&P Dow Jones Indices, April 2020
