With UK savings rates remaining high, you might be wondering whether it’s time to hold more cash in your investment portfolio.
Unlike shares and bonds1, there’s no risk of incurring a loss on cash savings. So, why take the extra risk when the returns on cash are more attractive than they’ve been for many years?
While this may seem like a rational argument, our research2 shows that holding too much cash in your investment portfolio could affect your ability to reach your long-term financial goals.
Read on to find out why excess cash can prove costly and how to work out how much you really need.
Emergency cash holdings
First and foremost, you should always consider holding emergency cash to cover against the unexpected, such as your boiler breaking down or a period of unemployment. Maintaining an emergency fund will reduce the risk of you going into debt or having to sell investments at a loss.
For one-off expenses, one rule of thumb is to keep the greater of £2,000 or half a month’s expenses in a bank account. When it comes to an income shock, we suggest keeping 3-6 months’ worth of expenses in an accessible savings account.
The cost of holding too much cash
Beyond your emergency fund, holding excess cash in your investment portfolio could cost you in the long run.
There’s a term in investing called ‘risk premium’, which is the additional return that investors get for taking on extra risk. When you invest in shares and bonds there’s a risk of losing some or all of your investment, but there is a premium to compensate for this. At Vanguard, we expect cash to deliver annualised returns3 of 3.4% over the next 30 years, compared with 6.9% for shares and 4.3% for bonds, based on average market conditions4. When we factor inflation into our projections, those figures decline to 1.4% for cash, 2.3% for bonds and 4.9% for shares.
Shares and bonds will experience volatility – or swings in prices – along the way. But that doesn’t mean you should move to cash when markets are particularly volatile. Doing so could have a long-term, detrimental impact on your finances.
The chart below shows how moving to cash for just a few months can lead to significant underperformance. It shows three examples of investor behaviour during the Covid-19 market downturn:
- Staying invested throughout (grey line);
- Going fully to cash in the week of 18 February 2020 and reinvesting in the week of 7 July 2020 (green line); and
- Going fully to cash in the week of 20 March 2020 (market bottom) and reinvesting in the week of 7 July 2020 (orange line).
The investors who fled the market – even those who sold out part way down – ended up with much lower returns than the investor who remained invested throughout.
Reacting to market volatility can jeopardise returns
Going to cash for just a few months can lead to underperformance
Past performance is not a reliable indicator of future results. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
Notes: The investment is in a portfolio made up of 60% shares and 40% bonds. Shares are represented by the FTSE Global All Cap Index. Bonds are represented by the Bloomberg Global Aggregate Bond Index (GBP Hedged). Currency hedging reduces the increase or decrease in the value of an investment due to changes in the exchange rate. It usually involves a separate transaction that is undertaken in the foreign exchange market before being converted into the investor's local currency. Cash is represented by the Sterling Overnight Index Average (SONIA) rate. Returns do not take into account inflation.
Sources: Vanguard calculations, using data from Morningstar, Inc. 1 January 2018 to 25 December 2023.
How much cash do I need?
So, what does this all mean for you? At Vanguard, we believe there are three things to consider when deciding whether to include cash in your investment portfolio: your risk tolerance, your time horizon and how close you are to achieving your goal amount.
Risk tolerance
Risk tolerance relates to how you feel about risk and is a measure of how much investment risk you’re willing to take. Cash’s low volatility means it tends to be suitable for investors with a lower risk tolerance. Whereas those with a higher risk tolerance are more accepting of the uncertainties associated with investing in the hope of better returns.
Time horizon
Your time horizon is how far away your investment goal is. At Vanguard, we generally think of a short time horizon as up to two years, intermediate between two and 10 years, and a long time horizon as anything over 10 years.
The chart below shows our expectations for cash, bonds and shares over one-year and 10-year time horizons. The coloured bars show the expected range of returns and the figures in the red circles show the expected median returns on an annualised basis. The data shows that the longer you invest, the narrower the expected range of annual returns, particularly when it comes to shares and bonds.
So, while shares and bonds are more volatile, long-term investors have more chance of riding out the market’s ups and downs and benefitting from the risk premium from shares and bonds. Cash is useful for those with a short time horizon because there’s no risk of a stock market decline depleting your wealth just before you need to access it.
Expected range of returns for cash, bonds and shares
Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.
Notes: Returns are from the Vanguard Capital Markets Model (VCMM) as of 31 December 2022 and are based on very long-term expectations where today’s market valuations have minimal influence. Returns are annualised. Shares and bonds are both defined as 95% non-UK/5% UK.
Source: Vanguard calculations, using data from the VCMM.
Funding level
Your funding level is how close you are to your goal amount. The better funded your goal, the less return you’ll need and therefore the less risk you need to take to meet your goal. This is where cash plays a role in preserving your portfolio. If your goal isn’t well-funded, holding too much cash could mean you end up with a shortfall, especially over longer periods of time.
Applying the framework
In practice, you’ll need to bring all the above factors together when deciding whether to include cash in your investment portfolio.
If you’re saving for a house in 18 months’ time, are close to meeting your target and have a low risk tolerance, a lower-risk portfolio with some cash might be appropriate. On the other hand, someone who is saving for retirement in a decade or so, is far away from meeting their target and has a high risk tolerance might choose not to include cash in their portfolio at present.
Bear in mind that things change over time. As you approach your goal, your time horizon will become shorter, you might be closer to meeting your target and your capacity to handle risk will likely reduce, so you may choose to shift some of your portfolio into cash.
1 Bonds are a type of loan issued by governments or companies, which typically pay a fixed amount of interest and return the capital at the end of the term.
2 Vanguard, “A framework for allocating to cash: risk, horizon and funding level”, April 2024.
3 Annualised returns show what an investor would earn over a period of time if the annual return was compounded (i.e. the investor earns a return on their return as well as the original capital).
4 Return expectations are 30-year figures from the Vanguard Capital Markets Model (VCMM) as of December 2023.
IMPORTANT: The projections or other information generated by the Vanguard Capital Markets Model® regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time. The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.
The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include US and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, US money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.
Investment risk information
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
Past performance is not a reliable indicator of future results.
Important information
Vanguard Asset Management Limited only gives information on products and services and does not give investment advice based on individual circumstances. If you have any questions related to your investment decision or the suitability or appropriateness for you of the product[s] described, please contact your financial adviser.
This article is designed for use by, and is directed only at persons resident in the UK.
The information contained herein is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. The information does not constitute legal, tax, or investment advice. You must not, therefore, rely on it when making any investment decisions.
Issued by Vanguard Asset Management Limited, which is authorised and regulated in the UK by the Financial Conduct Authority.
© 2024 Vanguard Asset Management Limited. All rights reserved.