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How much cash should you hold?

Cash provides liquidity and diversification in your portfolio
How much cash should you hold?

We frequently encourage people to stay invested where they can because timing the market is notoriously difficult and, generally, your returns will be higher if you stay invested over the long term. But it is still important to have a proportion of your portfolio in cash, both to meet a need for emergency funds and to provide you with diversification and liquidity. With classic safe-haven assets now looking expensive, the question of how much cash to hold has grown especially urgent.

The amount of money needed to cover emergencies depends on your investment time horizon. If you are retired and depend on your investment portfolio for regular income, you should have up to two years’ worth of spending money in cash to avoid having to sell assets when markets fall. If you have a very long time horizon, you might be comfortable with having three to six months’ worth of spending money to cover unexpected events such as redundancy.

Leaving aside cash used for emergencies, Adam Drummond, regional director at Rathbones, says a client with a medium-risk portfolio would currently hold about 4 per cent in cash. His view is that it is not worth taking profits on equities in anticipation of falls because trying to time markets is a “dangerous game” with prices moving so quickly, making it easy to get caught out. 

Even if you have a high risk tolerance, you are likely to benefit from having a proportion held in cash to take advantage of market opportunities as they arise. David Miller, investment director at Quilter Cheviot Investment Management, recommends having 5 per cent of your portfolio in cash ready to exploit market opportunities.

David Liddell, chief executive of online investment service IpsoFacto Investor, meanwhile, has 20 per cent in cash over a five-year time horizon for his average risk portfolios – a level that is partly so high to compensate for a low allocation to bonds.

Mr Liddell adds that the portfolios had 30 per cent in cash going into the crisis but put more into the market in the beginning of March. He wouldn’t look to reduce the cash amount at the moment as there is “quite a high probability there will be another market fall of some substance”.

Mr Liddell thinks that for people who have been fully invested since March, taking profits now “is probably not a bad idea”. However, timing the market is not an exact science. Kay Ingram, director of public policy at financial advice firm LEBC adds: “All the research suggests that long-term investors who stay invested in volatile markets usually do better than those trying to guess the highs and lows of markets.”  

 

Cash as a diversifier?

Viewing cash as an asset class and using it as a diversifier sparks a mix of opinions. Some advisers view cash as something your investment portfolio should have as little of as possible. You are guaranteed to make very low returns and your savings are likely to have their value eroded in real terms during times of inflation. 

Others see cash as a useful diversifier. Defensive assets such as government bonds and gold have traditionally been viewed as safe havens when equity markets fall. But they are currently looking very expensive, with bonds offering very low, sometimes negative, yields and gold recently touching record high prices.

“The attraction of cash is that it offers flexibility and certainty at a time when markets are very uncertain,” says Mr Drummond. “Clearly, there are disadvantages to cash if it is held over the long term as the value can be eroded by inflation, but at times of heightened market volatility, cash can offer protection if markets fall and then give you the ability to introduce investments at potentially lower levels”. 

As governments have been pumping vast amounts of stimulus into economies to prop up companies over lockdowns, it is not unreasonable to think inflation may rise, particularly if the economic recovery begins to exceed expectations, so you must be mindful of this if you hold elevated levels of cash.

Gold is viewed as the traditional fiat money inflation hedge. It typically performs well when equity markets perform poorly and has risen sevenfold since the turn of the millennium. The recent surge in the gold price suggests that markets may be starting to get nervous about the possibility of inflation. 

But the bond market suggests otherwise – the recent rally in bond prices, which has pushed down yields, suggests that markets may be sanguine about inflation, even if bond-holders have central bank purchases to thank for keeping prices high. 

Both gold and bonds risk losing you money in nominal terms if their prices fall. While cash will not make you money, it will not lose it either. Mr Miller cautions that gold should not be seen as an alternative for cash but as a store of wealth, as it can be hugely volatile. 

 

Where to hold cash

Many investment platforms offer cash accounts. This is convenient where holdings are being sold for reinvestment elsewhere, such as a 'bed and Isa' exercise where taxable funds are liquidated and reinvested in an individual savings account (Isa). It can also be beneficial to add cash to a platform to cover charges, so that investments are not sold down, especially if the investment is in a tax-efficient wrapper such as a pension or Isa – or during a sustained bear market. 

However larger sums destined for eventual spending rather than short-term reinvestment should normally be held in a cash deposit outside the platform. Many cash accounts offered by platforms pay little interest and some even charge platform fees on the cash. With today’s low interest rates you could be paying a platform for the privilege of holding your cash.

Some platforms such as Hargreaves Lansdown and AJ Bell offer distinct cash services. They rank the best rates from a selection of banks and allow you to place your money with those banks directly through the platform, acting like an online savings rate supermarket. At Hargreaves Lansdown you can currently open an easy-access account with Charter Savings Bank with an annual equivalent rate of 0.5 per cent, or 1.05 per cent for a one-year fixed term.   

Ms Ingram recommends placing large cash amounts in a range of accounts via a cash investment platform such as Akoni. The platform has more attractive longer-term rates than Hargreaves Lansdown and takes the financial strength of the bank into consideration, as per Fitch credit ratings.

When you sign up you complete a form and ID verification, noting your preferences for time frame, access and fixed or variable rate. The platform will present you with your best options. 

The Financial Services Compensation Scheme (FSCS) will protect up to £85,000 of an individual’s cash if an authorised financial services firm goes bust, and Akoni will notify users if they have breached this limit with an individual provider. Those above the £85,000 threshold should generally spread their cash across different providers.

For longer-term cash savers, National Savings & Investments is offering the best rates currently on instant access, paying interest of 1.15 per cent gross with government protection covering £1m per saver.

 

Alternatives to cash?

Buying index-linked government bonds could provide an alternative to cash and offer some protection should inflation occur. A good way to get exposure is via an exchange traded fund or a passive fund, such as Vanguard UK Inflation-Linked Gilt Index Fund (GB00B45Q9038), where the ongoing charge is low at 0.12 per cent. 

US Treasury Bills are also a popular alternative. By investing in T-bills you need to be aware that you are taking on currency risk, meaning if the US dollar weakens against the pound this will erode the value of your savings. Over the past five years the dollar has been strong, which will have benefited UK investors buying dollars. 

Ms Ingram thinks US treasuries could be a “relatively safe” alternative to cash. She says: “Currency gains could improve the return on investment if sterling weakens against the dollar in the wake of Brexit disruption to the economy, should the UK and EU fail to reach a trade deal”. 

However, currency watchers are now questioning if the greenback may be reaching a turning point. In recent weeks the pound has strengthened against the dollar, with a 10 per cent increase from March lows. The strong dollar has been influenced by US interest rates in recent years, which were higher than those on offer in other developed markets, but rates have now been slashed to near zero. The US presidential election may also create more volatility in the dollar before the end of the year.

Mr Drummond says he has used T-bills as a helpful alternative to cash “over the past year or so” for larger cash deposits which would be above the £85,000 FSCS protection level, but given that yields have fallen even further the returns are negligible. He adds that global central bank policy is “likely to suppress bond yields for the next one to two years at least, meaning that returns on conventional gilts are not particularly attractive as an alternative to cash”. 

If you are using cash as a diversifier and think bonds and gold look expensive, infrastructure funds may have better prospects, adds Ms Ingram, “particularly if you believe that the chancellor’s July statement and the government’s 'Build Build Build' slogan will result in investment in this area later in parliament”.

You can invest in infrastructure via investment trusts. The average infrastructure trust, as categorised by Winterflood, had a yield of 4.8 per cent, but because these funds are popular they can trade on very large premiums. The average premium for the sector came to more than 16 per cent on 7 August.