Following the recent increases in the Bank of England base rate to 5%, you might legitimately ask why you should invest in volatile or “risky” assets when your cash is providing a return of 5%?
To discuss this topic productively, we must distinguish between the different reasons for saving money. A “safe” cash investment is the optimal place for the money you will require in the short term. However, this discussion is about how to allocate capital that will only be required in the long term such as using it to supplement your income when you eventually stop working or perhaps preserving your capital as a future legacy gift.
For simplification, we will use a diversified portfolio of global equities as the alternative option.
Defining Money as Purchasing Power
In my view, the only sane definition of money is purchasing power. It is only good to the extent that it can buy more in the future than it can today. The major challenge we face is that inflation (the steady rise in prices) corrodes this purchasing power, and our investment philosophy is designed to address this.
The Historical Performance of Cash & Inflation
History has taught us that cash does not provide a return greater than inflation after tax over the long term. Additionally, if the interest is not reinvested, our capital base does not grow either. A benefit of cash is very low volatility, but this comes at a very big trade-off in purchasing power over time
The Case for Global Equities
The alternative is a diversified investment in the great companies of the world, global equities. In this scenario, we are not lenders to banks or governments but owners of real, profit producing, productive companies. Think about the everyday products and services you use; most of not all of those companies will be amongst the great companies of the world.
Th profits declared by those companies are either re-invested into attractive projects or distributed to shareholders as dividends. This dividend is often lower than the return on cash, but this is only one element of your return.
The second element of your return as equity investors is the growth in the capital value of your shares. Historically, share prices have grown as corporate profits have grown. Corporate profits rise due to innovation and the ability to pass on inflationary price increases to consumers. This means that, over time, dividends also increase.
The net result is long-term returns which beat both inflation and the returns on cash. This is the engine that helps us preserve our money’s long-term purchasing power, which, as mentioned, is the only sensible definition of money.
The Trade-Off: Short-Term Declines for Long-Term Gains
There is a cost for earning this return: in exchange for better long-term returns, we must endure short-term declines in the value of our investments. These are always temporary and we do not know when they will occur. The only way to earn full returns as an equity investor is to stay invested at all times. I exist to ensure you stick with your portfolio through all market cycles. I believe a portfolio allocated to predominantly global equities is in your best interest and I treat my own long-term capital in the same way.
If you ever find yourself wrestling with the cash dilemma or you just in need of a friendly chat, don’t hesitate to reach out. We’re here to lend an understanding ear and a reassuring voice to keep you on track with your financial journey