Let’s face it, holding cash is safe, it’s dull, it’s predictable... and it can be a very good idea. This is particularly the case, as Warren Buffett would suggest, if it prevents us from doing something stupid with our money. That said, historically the price of holding cash is underperformance in the long-term in comparison with the likes of government gilts or equities.
Real Returns by Investment Class:
| 10 yrs | 20yrs | 50yrs | |
| (%) | (%) | (%) | |
| Equities | 5 | 7.4 | 6.6 |
| Gilts | 5.6 | 6.2 | 2.1 |
| Cash | 2.9 | 4.1 | 2 |
| Source: Barclays Equity Gilt Study 2006 | |||
The trouble with cash investing is that any fool can do it. Once you’ve deposited cash, the job is done and the skill level required from the investor is negligible. (At worst, you might need to make sure that your savings provider doesn’t shunt your nest egg into a quiet siding where it doesn’t earn so much interest, but that’s about the extent of it). And yet, year after year, millions of people opt on packing their money into deposit accounts which, after taking into account tax and inflation, can be of modest real benefit. What exactly drives this thinking?
Well, let’s start with the obvious explanations. Many don’t know very much about investing and prefer to stay with what they understand, which is cash. Some are in those phases of life (childhood, parenthood, retirement) where it really doesn’t make sense to take unnecessary risks with their money as there is a high level of dependence in the surety of their savings. But many more of them are shrewd and sophisticated operators who use the cash markets to ride out those strategic times when they can’t see anything worth buying in the equity markets. Wasn’t it Warren Buffett, again, who said that the hardest part of investing was knowing when to sit on your wallet and do nothing at all?
2007 looks like being one of those awkward years when Buffett’s advice might be worth heeding. Even those of us who don’t normally believe in selling in May and going away have been disturbed by the way that last month’s depressing figures for housing starts have rocked the American financial markets.
Meanwhile, the wobbles in the sub-prime mortgage lending market have got analysts worrying that US homeowners might soon start reining in their spending — with disastrous implications for profits... perhaps. If you then throw in a few worries about the growing international tension in Iran, a few more about emerging markets and a four-year-old bull market already long in the tooth, then you have no shortage of excuses to adopt a more cautious view.
Few manage to accurately predict a stock market downturn in advance but reducing equity exposure while all is well and increasing cash on deposit can help you sleep at night and avoids getting trampled underfoot in a downturn when there is a headlong rush for the exit.
Any sort of cash investment is good to hold in a downturn and, let’s face it, it’s the ultimate no correlated market asset. Ideally, you want your cash to be working as hard for you while you’re seeking more profitable ideas. So what are the options if you want to keep your back protected in these difficult times?
5.75% possible from online savings Accounts
We’ll assume, for the moment, that you’re not attracted by current accounts at your local bank. Oh, certainly you’ll get a short-term introductory rate of 3%, providing that you keep your account £1,500 in the black and don’t expect a lot of frills.
(Or, more probably, 0.1% over the longer term.) Alternatively, you might favour an integrated account like Virgin One, which will use your savings to offset your mortgage and will give you a 3.41% return on your spare cash. But most of us would rather have a separate, properly targeted cash savings vehicle that will allow us to grow our money rather faster than this.
The traditional way to save, and still one of the best, is to do it through a bank or building society account that will let you pay in as much as you like, whenever you like — and, if you want, to withdraw it whenever you like. Obviously you’ll usually do slightly better with a 30-day notice account than an instant access account — but you might be surprised at the high returns you can get from instant-access these days, especially with accounts that don’t involve physically walking into a bank. When banks can dispense with branches and unnecessary paperwork, it creates savings for them that they can pass on to you.
Thus, for instance, you can currently get 5.75% AER (5.6% gross) from an HSBC Online Saver account, which pays interest monthly, with instant access, and which has a minimum balance of just £1.
The Birmingham Midshires Direct Internet Savings account also starts at £1 and pays 5.5% AER (5.5% gross), but interest is paid only once a year. And the good old Post Office Savings account is still delivering 5.25% AER (5.25% gross), although its minimum balance requirement of £500 is looking a bit steep these days. All of these accounts allow instant access.
The surprising truth is that 30-day notice accounts don’t produce very much more interest than instant access accounts these days — barely 0.25%, in fact. You’ll struggle to find a notice account paying more than 6% gross, unless it’s just for a short incentive period.
Bear in mind that with all these accounts you’ll normally receive your interest payments net of basic rate income tax (20% for deposit savings), which will be deducted at source. If you qualify for income tax exemption — for example, if you earn less than the minimum tax threshold, or if the account holder is a child — you can get your interest paid gross by filling in form R85 and presenting it to your bank or building society. The form is available online, together with a help sheet, at http://www.hmrc.gov.uk/forms/r85.pdf.
There are numerous cash products aimed at helping children to build up nest eggs for the future — Child Trust Funds, special tax-exempt savings accounts, and large numbers of so-called bare trusts that are typically managed by investment professionals on behalf of your child.
Don’t forget National Savings
National Savings is a popular choice for people who prefer their cash savings to be tax free. The current issue of index-linked savings certificates isn’t anywhere near as flexible as a building society account, because it requires you to sign up your money for three to five years. But it pays up to 5.75% tax free on a minimum deposit of £500 — which, according to the NSI’s website (http://www.nsandi.com/products/ilsc), is equivalent to an attractive 9.58% for a higher-rate taxpayer. As its name suggests, your actual return will be linked to the retail price index. Or, to be precise, it will be 1.15% above the RPI on the 41st issue three-year bonds and 1.1% above RPI on the five-year certificates. RPI is currently running at 4.6%, so the 5.75% figure quoted by NSI seems to stand up well to scrutiny.
£3,600 into a cash ISA from 2008
Cash ISAs might be ignored by experienced stock market investors, but they are a popular choice for those starting out on the savings ladder. They sell in their millions to those more comfortable with cash in the bank than the uncertainty of more risky investments. This has proved a good choice recently as the best cash ISA providers have been running the markets a very close second in the last 12 months — and, if this year turns out to be as wobbly as some are predicting, they could leave a good many experts wishing they’d had the sense to play it safe.
At present, you can put only £3,000 a year into a cash ISA (over 16s only), but from April 2008 the maximum is due to rise to £3,600. All your interest is paid tax free — whereas the dividends from a stocks and shares maxi ISA are subject to a tax charge. You can (usually) withdraw some or all of your cash without notice, but you won’t be able to put it back in again if it takes your annual in-payment beyond the £3,000 limit.
Probably the most popular cash ISA at the moment is the National Savings & Investment Direct ISA, which delivers 5.8% AER (tax free) on a minimum deposit of £1,000. But it’s far from being the best deal, especially if you take into account the many introductory offers that will boost your interest rate during an initial period.
One of the tastier offerings at present is the Barclays Tax Beater Cash ISA, which offers you an extra 1% on your first year’s interest, bringing the total return to 6.5% AER (6.31% tax free). That headline figure is slightly lower than the 6.55% tax free that you’d get from the ING Direct Cash ISA, but ING’s rate includes a shorter incentive period of just six months instead of 12. You can open either with just one pound, and both ISAs allow instant withdrawals on demand.
You might also like to consider the 15 Day Notice ISA from the Portman Building Society, which pays 5.65% AER (6.05% gross) with instant access on a minimum £1,000 investment. Or the 5.72% AER (5.9% gross) 30 Day Premier Account from the Tipton & Coseley Building Society.
What happens to your money if your bank goes bust
Under British law, your money is protected from the possibility of your savings account provider going bust — but only up to a specified cash limit. The Financial Services Authority operates a mandatory Financial Services Compensation Scheme, which guarantees 100% of the first £2,000 you have with any lender, plus 90% of the next £33,000. This makes rather a nonsense of the £2m investment limit that you’ll find with accounts like Birmingham Midshires, because you’d be insane to keep more than the protected limit with them. If you have more than £35,000 to invest in cash accounts, make sure that you spread it around for maximum protection.
Your security might be slightly reduced if you save through non-mainland or non-UK accounts, including those in the Channel Islands, Dublin or the Isle of Man. Although these offshore institutions will be subject to comparable regulations, it’s worth checking the small print as to the limits of the compensation scheme applying to the jurisdiction in which your money is held.
Inflation risk
Aside from the remote risk that your bank or building society could go bust, the main threat to holding your money in cash is inflation.
There’s not going to be very much benefit in a 5.5% interest rate if there’s tax to pay and inflation’s running at 4.6%. In such a scenario, you would be getting progressively poorer in real terms and you’re not going to make your money work sufficiently hard to pay for much in the way of a luxury retirement. In the longer term, it’s going to take more risk to achieve that kind of growth. But, in the near term, given strong equity returns in recent years the option to hold cash should not be overlooked as battening down the hatches before a storm tends to work a whole lot better than midway through it.
Action to take: For further details on the best savings rates check out www.moneyfacts.co.uk. and national savings www.nsandi.co.uk.
