What to consider as rates decline
The Bank of England finally cut interest rates in August to 5%, the first drop in rates since March 2020 (when the UK’s initial Covid lockdown was imposed). The likelihood is that many more cuts could come in the next year and beyond. This will obviously have an impact for savers and returns may not align fully with the Bank’s trajectory – they could fall faster.
So the questions most savers should consider is, what are your plans for your money? And what timeframe do you have in mind to access the bulk of your savings?
If you have relatively short-term plans you may want to keep some of your savings in cash, for easy access. The level of your cash requirement will vary depending on your stage of life – for those who have a sufficient level of income to meet their outgoings, they may only feel the need to hold a small amount in cash, perhaps up to six months’ worth of savings. The purpose of these funds is to then cover any unforeseen emergencies or known upcoming expenditure.
The situation may differ for individuals who rely on their assets to meet their income needs – those in retirement, for example, may choose to hold more cash than they have done previously. In this case, they may wish to hold 12-24 months of expenditure as savings. In addition to providing for emergencies and expected purchases, the funds can also be used to meet their income needs during volatile periods in markets when their investment assets may have dropped in value. They can therefore avoid liquidating investments to fund their income, which would more quickly erode their overall pot.
So while it is clear there is a role for cash in our financial plans, with interest rates set to fall further, the question is how much cash should you hold? Is your money working as hard as it should when cash savings are not a long-term solution?
Why cash savings are a poor substitute for investing your money
First of all, we should acknowledge that saving into a pension qualifies for tax relief of at least 20% (more for higher rate taxpayers), an annual boost you don’t get if you simply park money in a savings account. This uplift could be substantial – resulting in thousands of pounds extra for most people over a number of years.
We should also compare the outcome over the long term to highlight why cash returns are a poor relation to investing. Let’s see what would have happened to £100,000 from the end of 2007 to the end of 2023. (We choose this timeframe as it covers the crash of 2008 (and the pandemic), to show that markets do typically bounce back and to underline that there will be periods of volatility.)
The findings, as illustrated in the chart below, are clear: investing in a mixed portfolio beats cash savings hands down over the long term.
For this example, we have chosen a medium risk portfolio (a higher risk portfolio would typically provide an even greater investment return). This invests in a mixture of global stocks and bonds to provide valuable diversification.
Over the period, cash returns – in real terms – have suffered immensely due to the impact of inflation. The investment return below also takes inflation into account and would comfortably have given you much higher returns in this timeframe.
How inflation affects cash and medium risk investments
Simulated historic performance is not a reliable indicator of future results.
Source: Netwealth and Bloomberg. The values represent £100k invested in 1 month Libor (a wholesale interest rate) and an example Netwealth Risk Level 4 portfolio minus UK RPI (a measure of inflation). Data to end December 2023.
How time and risk make a difference
As evidenced by numerous timeframes going back over 100 years, investment returns are likely to be positive over the long term (generally, 10+ years). Yet in the short term it’s almost impossible to know what level of returns financial markets will give you, or to predict when markets may go up or down. We therefore recommend you stay invested for the course rather than trying to time markets.
If you do try and time the market, there is a real risk you miss out on a strong period of market returns – these can often be short but sharp and are the periods a portfolio needs to capture. These phases of strong market returns can also occur when a downbeat narrative prevails around the domestic or global economic situation – this is because there is often a disconnect between what’s going on in an economy and how markets behave.
Importantly, when investing you should choose the level of risk for your portfolio that is appropriate for your circumstances. This means you should consider your objectives, how long you are planning to invest and your ability, willingness and need to take risk. These attributes of risk are important because how much risk you take is key to determine how much your investments can grow over time. We can sum them up briefly as:
- Risk ability
Your ability to take risk is driven by your overall financial circumstances and for how long you wish to invest.
- Risk willingness
Your willingness to take risk represents the level of fluctuations you are willing to accept in the value of your investments, and in the size of a potential short-term, medium-term and permanent loss.
- Risk need
Your risk need is the amount of risk you may need to take to achieve the returns required to meet your goals. For example, more risk will typically lead to higher returns over the long term, but you may suffer greater short-term volatility.
Whatever your attitude and ability to take risk, our powerful online planning tools can help you to visualise your possible financial outcome more clearly. You can try multiple permutations of risk, money invested and timeframes to assess how changing these parameters could affect your plans.
A financial planning ‘MOT’ could also help you to examine if you are on track to achieve your objectives. Find out how to make your financial plans more effective – and maximise your financial circumstances – with personalised projections and guidance from an expert adviser. You can sign up for the service here.
Investing for positive long-term outcomes
It’s hard to say how quickly interest rates will come down, but we know that savers are already being affected. So while nobody has the ability to predict events, it is sensible to anticipate them, and prepare where you can.
Interest rates soared chiefly because of extraordinary events: the pandemic, war in Ukraine, supply-chain challenges and the resulting inflation shock. Unexpected events can occur with some frequency (before the pandemic was the great financial crisis in 2008, before that the dotcom crash in 2001), but leaving your money in a bank account is clearly not the ideal way to prepare for them and overcome their impact.
Where you are looking for a long-term investment solution (or objective, such as saving for retirement), this requires a proven long-term approach. Investing your money – and making peace with the various gyrations along the way – is the best strategy to grow your wealth and help you achieve your goals over time.
Please get in touch if you would like to know how we can help you to prepare effectively for your future.
Please note, the value of your investments can go down as well as up.
Netwealth offers advice restricted to our services and does not provide independent advice across the market. We do not offer advice in relation to tax compliance, personal recommendations with regards to insurance and protection, or advise upon the transfer of defined benefit pensions.
