Having cash reserves is important. Most people need a “rainy day” fund to cover unforeseen events, and for the purpose of saving towards shorter term goals cash is appropriate because it has the significant advantage of offering security of capital. Some investors also like to hold some cash to take advantage of opportunities in the market as they arise.
Yet holding too much cash for long periods can be costly. Inflation can gradually eat away at the spending power, and following a period of very low inflation it has accelerated in the past couple of years. The latest reading of the Consumer Prices Index was 3%, and if your savings are returning less than this each year then their spending power is diminishing.
It may still seem like 3% is a small number to be concerned about, but the relentless cumulative effect of inflation over time can be hugely detrimental for those keeping large sums in cash and attracting interest at a lower rate. For instance, each £1 you spent in 1995, you would need to spend £1.83 today. Earning a competitive rate of interest on cash will certainly help but it is difficult to earn an inflation-beating amount, especially in the current environment of low interest rates. Thus by keeping too much in cash investors could be at risk of not making the most of their money – or not achieving their long term investment goals. It's the most common investment mistake of all.
Unlike cash, riskier assets do not offer security of capital, but over the long term they tend to do better than cash in providing a return above the rise in the cost of living, and therefore they build your wealth more effectively. Although it can be daunting to make the switch from saving cash to investing it, it can be beneficial in the long run. Once you have a good cushion of cash savings, enough to cover 6 to 12 months’ worth of living expenses for instance, then it may make sense to invest any surplus.
Shares are more likely to outperform cash the longer you invest. Company earnings have the potential to grow faster than inflation over the long term, and this can drive both share prices and dividend payments higher, though unlike cash the value of investments and income can fall as well as rise so you could get back less than you invest. This is why investing is only for those prepared to commit for the longer term – five years as a minimum – in order to have a better chance of riding out market ups and downs.
Shares in firms with “pricing power”, whose products and services are in strong demand, can put up their prices to reflect higher costs, and should, in theory, be well placed to cope in an inflationary environment. A good starting point is funds or investment trusts in the equity income sector. These look to invest in companies that can grow profits and dividends over the long term in order to provide a healthy and rising flow of income to investors.
The equity income sector has some of the UK’s best fund managers, and with rates on cash and bonds very low yields in the region of 4% look attractive, especially as they offer the potential for income and capital to grow over time. All yields are variable and not guaranteed. For investors prepared to accept the additional risks and fluctuations in their capital we believe equity income funds could offer a valuable shelter against inflation.
This website is not personal advice based on your circumstances. No news or research item is a personal recommendation to deal. Investment decisions in fund and other collective investments should only be made after reading the Key Investor Information Document or Key Information Document, Supplementary Information Document and/or Prospectus. If you are unsure of the suitability of your investment please seek professional advice.