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Everybody should have some money set aside in a savings account for a rainy day but is it a good idea to have cash in your investment portfolio?
Cash invested in a money market fund, which invests in highly liquid assets, provides stability during periods of financial market turbulence and allows you to exploit investment opportunities without having to liquidate other assets. It is also prudent to invest an increasing proportion of your portfolio in highly liquid and stable assets as you approach retirement. However, a significant cash holding carries drawbacks and there are alternatives.
The price of inflation and deflation
Surprisingly, both inflation and deflation can adversely affect a cash holding. The effect of inflation is clear. If the interest you are earning in the money market fund is lower than inflation your buying power will erode as time passes. Moreover, the price of some assets, such as property, has run at much higher levels than the Retail Price Index in recent years. Annual house price inflation in England and Wales, for example, amounted to 5.3 per cent in the year to end September 2015, according to the Land Registry. By contrast, annual inflation, as measured by the Retail Price Index, stood at 0.8% over the same period. For these reasons, choosing cash rather than equities, government bonds and commercial property could have had a significant impact on the value of your portfolio. It is important to note that the past is not always an indicator of what will happen in the future.
Bonds – the long and the short of it
The impact of deflation is less obvious. If the price of goods falls, then your cash will have greater buying power. However, government bonds, for example, tend to perform well during periods of deflation. This is because the fixed income they provide is increasingly attractive. Bonds issued by the most financially-secure governments and companies are generally considered less risky than equities but more so than cash. In an environment where interest rates are very low in relation to the norm before the global financial crisis, you could also potentially earn a higher return by investing in bonds rather than leaving your savings in cash.
Government bonds with a relatively short-life span of a few years are an alternative to cash that is worth considering. This is because these ‘short duration’ bonds, as they are known, are less sensitive to a rise in interest rates, which lessens the appeal of the fixed income from bonds, than those issued over longer periods. It is important to note that the price of bonds can go up and down and your capital may be at risk.
About absolute return and multi-strategy investing
There is another alternative to holding a significant amount of cash. Absolute return and multi-strategy funds aim to deliver steady positive returns regardless of whether markets are rising or falling. Given that these funds aim to protect the investor from falling markets they could provide an attractive alternative to purely holding cash. However, it is important to note that although these funds aim to deliver steady growth, there is no guarantee. It is also worth noting that absolute return and multi strategy funds would normally limit the amount of growth realised in growing markets. Put a different way, these funds try to smooth the potential bumps that can come with investing, which is exactly what you might be trying to achieve by holding cash.
It is important to note that the value of an investment and any income from it can go down as well as up. You may also not get back the original amount invested.
Except where stated otherwise, the source of all information is Aviva Investors as at 1 November 2015. Any opinions expressed are those of Aviva Investors and they should not be relied upon as indicating any guarantee of return from an investment in our funds. Nothing in this document is personalised advice or a recommendation. If you need a personalised recommendation based on your personal circumstances, you should seek financial advice.
Past performance is not a guide to the future.
Issued by Aviva Investors UK Fund Services Limited, Registered in England No. 1973412. Authorised and regulated by the Financial Conduct Authority. Firm Reference Number.119310. Registered address: No 1 Poultry, London EC2R 8EJ. An Aviva company. www.avivainvestors.co.uk