Why having cash reserves can help maintain your investment’s growth potential

01/03/2023

According to FTAdviser, 69% of high net worth individuals under 55 are more cautious about their investments due to fears around the economy and high inflation. Nearly 6 in 10 (59%) of investors over 55 said they had become more cautious due to the economic climate at the start of 2023.

It’s understandable when you consider that the Guardian revealed that the UK’s economy flatlined in Q4 of 2022, meaning it narrowly dodged a recession. As the definition of a “recession” is two quarters of economic contraction, you could argue it only missed a recession on a technicality.

Furthermore, the UK’s chancellor, Jeremy Hunt, said the UK’s economy “was not out of the woods yet”.

If you’re a high net worth investor and are concerned about the UK’s financial situation, you may need to take care not to become overly cautious, as it might be bad for your wealth. Read on to discover why this is, and why our philosophy around cash reserves could help optimise your portfolio’s long-term growth potential.

Potential growth comes with risk

As clients of Douglas White Financial Planning (DWFP), you’ll know that growth potential typically comes from the higher-risk assets that are held within your investments, such as stocks and shares. These are otherwise known as “equities”.

Typically, the more higher-risk assets included in your investment portfolio, the greater the growth potential. There is a catch with this, however, as stocks and shares also expose your money to greater risk of losses.

This means that the greater proportion of equities within your portfolio, the higher the chance of it falling in value if the stock market suffers a downturn. The good news is that equities have tended to increase in value over the long term, something research by Schroders backs up.

According to the study, if you invested in the US stock market for one month between January 1926 and January 2022, you would have lost money 40% of the time (when inflation is taken into account).

If you invested for 10 years, the potential for loss drops to 14%, and if you invested for 20 years you would not have lost any money.

Lower risk typically means lower growth potential

If you still wanted to reduce the risk and possible losses, you can include lower risk assets in your strategy. These could include government bonds – otherwise known as “gilts” – cash, or even commercial property. It’s worth noting here that “lower risk” does not necessarily mean “risk-free”.

The catch here is that doing this could significantly reduce your money’s growth potential, as highlighted by the following illustration. It’s taken from the 2019 Barclays Equity Gilt Study, which tracked the performance of £100 invested in cash, gilts and equities between 1899 and 2019:

Source: Barclays

As you can see, equities provided significantly more growth than gilts during the period, despite downturns along the way. So, with this in mind, let’s consider why reducing your investment’s risk by too much could reduce your wealth’s value in real terms.

Lower-risk investments may not keep pace with inflation

In January 2023, the Office for National Statistics revealed that UK inflation – which measures the rising cost of living – stood at 10.1%, although the Bank of England predicts it will be 4% by the end of 2023.

If you reduce your investment’s risk level too much, you could reduce its growth potential to a point where it cannot keep pace with inflation – even if it does drop to 4%. This is why we at DWFP work hard to optimise the growth potential of your money, while keeping it at a level of risk that’s right for you.

Central to this is our philosophy of ensuring you have adequate cash reserves, something we’ll look at next.

Having an adequate cash “buffer” is key to investing

Having enough money in cash helps protect you from a volatile stock market or economy. This is because you can maintain your lifestyle and ride out any downturn in value your investments may be experiencing.

This is why ensuring you have the right level of cash reserves is at the heart of our financial philosophy, and as a client, you will probably be familiar with how we split our cash holdings into three different pots. This involves holding different “funds” of cash in accessible accounts that allow you to plan for and deal with every eventuality.

Most important of all, it minimises the risk of you needing to access your investments if the stock market suffers a downturn, realising losses and resulting in your money losing value. With this in mind, let’s look at each fund in more detail.

Fund 1 – Emergency fund

An emergency fund ensures you have money that’s easily accessible when life’s unexpected, and unwanted, events happen. This could be the boiler blowing up or your home’s roof needing to be repaired.

While the amount you have in your emergency fund depends on your circumstances, the minimum amount should be three to six months’ worth of expenditure. That said, if you are a retiree taking drawdown, we suggest that you have up to three-year’s worth of drawdown to help avoid “sequence risk”.

Sequence risk happens when you draw an income from your pension during a stock market downturn, meaning you’ll need to sell more equities to maintain your level of income. This could then deplete your pension earlier than expected.

Switching off your pension income during a downturn and living off your emergency fund until the market picks back up could help preserve your retirement fund’s longevity.

Fund 2 – Planned capital expenditure

While emergencies are completely unknown and unexpected, there are certain larger expenditures you can plan for that would typically not be covered by normal income. We refer to this as “planned capital expenditure”.

This is used to achieve significant life goals, such as funding the expensive holiday that you take once in a while, buying a new car, or having the kitchen replaced. Having this fund means you do not have to use the investments you may need to rely on later on, or dip into your pension pot, which may exhaust it earlier than expected.

Fund 3 – “Stuff it” fund

How good would it be to find out your favourite band was playing in Barcelona, and to be able to book tickets without thinking about the financial implications? This is what your “stuff it” fund is for.

It’s for those life-experiences that put a smile on your face, allowing you to get the most out of life without then worrying about the financial implications. Again, this ensures that you don’t need to dip into your pensions or investments and suffer losses to do the things you really want to.

Get in touch

As you can see, having an adequate level of cash reserves could not only help you enjoy life to the full, but it also provides peace of mind. More importantly, it allows you to optimise your money’s growth potential because you can continue to take on an appropriate level of risk.

If you would like to discuss your cash buffer, or are not a client and would like to understand how our three-fund system could help your investments and wider wealth, please contact us. You can get in touch on info@douglaswhiteltd.com or by calling 0151 345 6828.

Please note

This blog is for general information only and does not constitute advice. It should not be seen as a substitute for financial advice as everyone’s situation will be different. Please do not act based on anything you might read in this article.

All contents are based on our understanding of HMRC legislation, which is subject to change. The information is aimed at retail clients only.

The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.

A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits.