Cash is the asset that savers understand best, whether it’s the notes and coins they use to shop with, or the bank accounts they use to hold larger amounts of money. But this doesn’t mean that everything’s straightforward when it comes to making decisions about cash.
Our familiarity and trust in cash starts from a young age when we receive pocket money from parents and grandparents. Perhaps your parents also set up a cash savings account for you when you were young?
This familiarity makes cash feel safe – and most of the time it is.
The big disadvantage of cash is the return that is earned, particularly in the current world of low interest rates. Depending on how and where you keep your cash, it may even struggle to keep pace with inflation, meaning that the purchasing power of your money falls from year to year.
So, when should you hold cash and when is it better to consider other investments or assets?
When using cash could be effective
As an emergency fund
We all have to cope with unexpected events in our lives, so setting aside some cash for a rainy day is a wise thing to do. Some people of working age choose to follow the adage that they should aim to keep at least three months’ worth of normal expenditure in cash, and ideally six months’ worth.
To achieve this, someone normally spending £2,000 a month could aim to build an emergency fund of somewhere between £6,000 and £12,000. Someone who has retired, with a main source of income consisting of withdrawals from a pension fund (‘income drawdown’), could aim to keep at least 12 months of income as cash and perhaps up to 24 months.
For short-term purchases
If you’re saving up to pay for something any time in the next five years, then you should consider keeping your money in cash. Examples include saving up to buy a car, a deposit on a first home or helping older children pay for university fees or the cost of student accommodation.
To pay off short-term high interest debt
Most people of working age have some form of borrowing, such as a mortgage or car loan. In these cases, there’s no need to pay off your debts before you start saving or investing. However, if you have shorter-term high interest debts such as credit cards or payday loans, it makes good financial sense to pay those off as quickly as possible. This is because the interest rates payable are so much higher than you would be likely to earn from savings or investments.
If you’re planning to take all your pension savings
Another group of people who could make effective use of cash are those who are retired, or about to retire, and are planning to take all of their pension savings over the next four or five years.
People with small pension pots may decide that they don’t have enough pension savings to last a lifetime and instead take their pension savings over a shorter period. They do this firstly because the amounts received are more meaningful, and secondly because it is usually more tax efficient to spread withdrawals over a few years rather than take the whole lot in one go. If you plan to take and spend your accumulated pension pot over a short period, keeping it as cash would avoid the potential short-term losses that may happen if you invest in other assets.
When you should consider other assets
For medium or longer-term capital expenditure needs
This means financial goals where the need arises more than 5 years from now. For example: funding university fees in advance for younger children, saving for retirement, or funding the cost of long-term care. Other investments like shares (stakes in the ownership of a company), or bonds (fixed-interest loans to a company or government) have historically produced better returns than cash over the medium and longer-term, although there is no guarantee that they will continue to do so in the future.
If you’re taking income withdrawals from your pension
There’s another important group of people who might want to consider alternatives to holding money as cash. These are people who are retired, or are about to retire, and are taking income withdrawals (sometimes called ‘drawdown’) from pensions which they hope will last for their entire lifetime.
Because they’re looking for the best possible return over a typical timespan of 25 to 40 years, other long-term investments historically tend to do better than cash. This is, of course, based on past performance which shouldn’t be taken as a guide to the future and can’t be guaranteed.
If you’re still saving for retirement
The greatest risk associated with investments like shares or bonds is that you might at some point have no option but to cash them in. An example of this would be if you needed to take income from your pension.
However, those who are still saving for retirement have time to ride out the ups and downs of more volatile investments. In fact, a fall in the value of investments means that your regular contributions will be buying more units in a fund when the price is lower. This is good news if the value of those units is higher at the point you want to take withdrawals.
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