Saving for a rainy day or a future opportunity

When interest rate increases are announced, the focus is naturally on what that means for homeowners. The impact of rate the rate increases on investors with cash and fixed interest holdings has been less commonly discussed, but for those who are lucky to be less affected by mortgage rate increases it's an important topic to consider for their overall portfolio.

While Paul Clitheroe’s recent article looked to challenge people who had been quietly putting away excess cash – reminding us that cash, as a long-term investment is “an absolutely terrible investment”. This article is for investors who have ignored cash’s role in reducing volatility and the importance of liquidity.

The underlying role of cash

The role cash plays as a holding in a portfolio goes beyond providing investment returns. Two important contributions a cash holding makes in a portfolio is providing:

1. Liquidity (quick access to money), and
2. Dampening volatility

The first of these, providing liquidity, is easily understood. Cash allows quick access to funds that can be spent. Even a term deposit, which we tend to think of as set aside for a fixed period, often has conditions that allow early access to the funds invested in the term deposit at the expense of some or all of the interest. 

The second role of cash, dampening volatility, is more complex. Having a cash holding in a portfolio reduces the exposure of the portfolio if there is a downturn in growth assets. However, this is not a free lunch, with the protection coming at the cost of a lower expected portfolio return.

The table below sets out the relationships between the expected return of a portfolio, the level of cash holdings, and the exposure of a portfolio to a share market downturn. 

To understand the table, consider the second row which is an approximation for a ‘growth’ style portfolio. With 20% of the growth portfolio invested in cash earning 5% pa, and 80% of the portfolio invested in shares earning 10% pa, the expected return from the whole portfolio is 9% pa.  If there was a modest share market downturn of 15%, an 80% growth portfolio would be expected to fall by 12%. A significant downturn of 40% would see a 32% fall in a growth portfolio.

The impact of cash holdings on portfolio downturns

There are two actions that come from this discussion.

1. Liquidity. Think about what cash is needed over the next 3 to 7 years (paying a pension, paying expenses like repairs, a new car or travel), and consider whether cash holdings are adequate. With share markets toward long-term highs, now might be a good time to set aside extra cash, if needed.
2. Volatility. Think about the trade-off between cash holdings and investment returns, and consider whether the balance is right in your portfolio.

Don’t be lazy with your cash

A simple resolution that stems from a higher cash rate is to make sure your current cash holdings are ‘getting their fair share’. A couple of years ago, when all bank accounts seemed to be receiving measly interest rates of less than 0.5% pa, there was no urgency to look hard at different cash rates. However, with interest rates of 5% per annum, holding larger balances in transaction accounts that are still paying little interest makes no sense. Even $10,000 would earn $500 of interest over the year in an account or term deposit with a 5% interest rate.

Spending some time considering how much cash you have, and the interest it might earn if you take the time to find an effective cash account or term deposit, could pay off with the current higher interest rates.

It’s well worth your time to consider how much cash you have, and the interest it could earn in a good cash account or term deposit.

Paul Clitheroe’s article cited ACCC data that showed the actual return people received for their cash holdings was below the RBA’s cash rate – one that had him suggesting we should make an effort to seek a solid return on our cash.

Consider building a strategic reserve

An important role of cash in portfolios is that it allows an investor to be a strategic buyer during a downturn. We have seen two relatively recent downturns, the Global Financial Crisis and the Covid-19 downturn, that saw the value of shares in Australia fall by almost 50% and 40% respectively.

We now know that these were great purchasing opportunities, leading to attractive returns for the bold investors who were buyers, not sellers, during the downturns.

If you are buying when markets have fallen, the lower prices mean that purchases are buying greater numbers of shares because prices are lower. You don’t need to feel like you have to set aside significant amounts of cash to make a positive difference as a buyer during a downturn.

Setting aside some cash now, or building a plan to increase the cash holding, so you can be a buyer during the next downturn is a strategy worth considering.

Be patient with fixed interest investments

Fixed interest investments are an asset class that tends to decrease in value as interest rates rise and, increase in value as interest rates fall. Over the past 20 months, the performance of fixed-interest investments has been mixed, as rising interest rates have been partially offset by strong demand for safe-haven assets.

The ASX Cash Rate Futures now has interest cuts expected over the next 18 months. If the returns from the fixed interest part of a portfolio have been disappointing, it would be consistent with rising interest rates.

Don't ignore the value of defensive investments

Until recently we have never seen the RBA with a cash rate target of 0.1%. We can also say that we have never seen a period of time when the RBA cash rate target increased from 0.1% to 4.35% over the period of about 20 months.

That puts us in a position where thinking about the defensive investments in a portfolio, cash and fixed interest, might have particular value.

Now that cash investments are providing a more attractive return, considering whether cash holdings are providing enough liquidity (access to cash), protection against volatility and possibly providing the opportunity to make purchases in the next downturn, is prudent.  Further, the sharp increase in interest rates may have reduced returns from fixed interest investments - however this is consistent with what would be expected, and should not be a reason to overreact.