Please note this bulletin is for general information purposes only and should not be considered personal financial advice. Investments carry risk and you may get back less than you invest. Past performance is not a guide to future performance and the value of investments may fall as well as rise.
As a space nerd, I’ve always been fascinated with the concept of the Goldilocks zone. In astrobiology it refers to what is also known as the ‘habitable zone’ – the area around a solar system’s star that could potentially contain planets with liquid water, and therefore support life.
A planet in the Goldilocks zone is neither so close to its parent star that it’s too hot, nor so far away that it’s too cold. Somewhere in the middle is just right. With the James Webb telescope making exciting discoveries now on almost a daily basis, more and more orbital Goldilocks zones are being found. All of which takes us baby steps towards the potential discovery of extra-terrestrial life. How exciting is that?! Well, provided they’re not looking back at us planning an invasion of earth. We’ve all seen Independence Day… But that’s not what I’m writing about today.
The Goldilocks zone – perhaps unsurprisingly - often finds application in finance too, as economists love metaphors almost as much as they love acronyms. Take the economic growth Goldilocks zone for example. When economies aren’t running too hot that they’re likely to form an economic bubble, which can pop. But not running too cool that they begin to contract and slide into recession. The ideal economic Goldilocks zone is where your economy is growing at somewhere between 2% to 3% per annum. Not too hot, not too cold; just right. Incidentally, the UK is likely to bask in this hallowed zone this year if things continue much as they did in H1 of 2024. Hurrah for the UK! But that’s not what I’m writing about today either.
Today I’m talking about cash. Not the ‘under the mattress’ kind of cash, but the optimal amount of cash you should hold in the bank on deposit, versus how much you should have invested. This is a popular area of discussion with our clients, and it’s been cropping even more than usual of late, given elevated savings rates, and the latest rally in global stock markets.
Getting the balance right between holding a healthy reserve of cash, whilst investing your surplus capital for growth, can help make you more financially secure, and optimise your overall return on capital. The woolly answer to the question ‘how much should I invest?’ is ‘not too much, not too little’. But that’s not very helpful. Whilst the right answer is different for everyone, figuring out this optimal position – your Goldilocks cash pot - is easier than you might think.
Cash is king...or is it?
We’ve all heard the saying: ‘cash is king’. A term often used by those who purport that when the chips are down, money in the bank is what’s important.
Like most enduring axioms, there is some truth to this. Liquidity is important, for both businesses and individuals, and keeping a healthy sum of money on deposit is vital to any healthy financial plan.
But whilst keeping a suitable reserve of cash in the bank is important, roosting on too much for long periods can also be bad for your wealth. This is because cash, whilst stable, struggles to beat inflation over longer time periods. The chart below looks back ten years, showing the return you might have achieved on a high interest savings account (blue), comparing it with CPI, the consumer price index, the main measure of inflation in the UK (red).
So, whilst cash might be king in a sudden emergency, it’s royal status is very much debatable over longer periods, as the royal vault tends to get plundered by inflation.
Conversely, one of the best hedges against inflation are stock market investments. Over longer time periods a good investment portfolio is likely to outshine both returns on cash saving and inflation. The chart below again looks back ten years, but this time it adds the past performance our two most popular portfolios, Tatton Tracker Balanced (green) and Tatton Tracker Global Equity (teal).
So clearly investing is a much better hedge against inflation, and the best way to ensure your money is generating a real return (i.e., growing faster than inflation).
However, before you start shouting ‘BUY! BUY! BUY!’ at your computer screen like an eighties stockbroker, we must remember investments are volatile by nature and even a relatively low risk portfolio can suffer sudden dips every now and then. Temporary retraces are of course all part and parcel of investing, and we know that a well-diversified portfolio will recover given a little time. When a storm hits, all you need to do is keep calm and carry on.
But to do so calmly and confidently, you need that healthy reserve fund in cash to soak up any lump sum capital expenses in the meantime. Otherwise, you may find yourself forced to sell-down a lump sum from your investments just at the wrong time, converting a recoverable loss on paper, into an actual painful loss. The chart below focuses on the year 2020 when the Covid crash occurred. Imagine being over-invested and then needing to access a chunk of your portfolio in March. Ouch.
This is why it’s important to always keep the right amount of cash on deposit. Your own personal Goldilocks cash pot – not too much and not too little.
So how do we calculate this? To establish what an optimal cash reserve looks like in any given situation, I apply a ‘rule of three’ approach.
You’ve probably already heard me talk about the ‘rule of three’ during our financial reviews. But it bears repeating, as even if we've done this exercise before, it’s worth regularly revisiting, as it will change over time. In short, you should always keep the following three things on deposit:
1. Emergency fund
We should always have a rainy-day fund, held in some sort of high interest instant access savings account. Part psychological comfort blanket, part practical reserve fund, for those unforeseen ‘OMG’ moments in life, where you need to find cash suddenly without warning. A common metric is six months of net income, or six months of basic essential spending.
2. Forthcoming capital expenditure
If you have some big-ticket expenditure coming up in the next three years, that you cannot fund from surplus income, this should also be set aside on deposit in preparation. For example; an elaborate family holiday, your daughter’s wedding, changing your car, or embarking on a building project. If you can’t cover it from surplus income, keep it held on deposit and ring-fenced ahead of time. Depending on the timescale and intention, you can either use a high-interest instant access savings account, or sometimes a fixed term bond, to tease out a little extra interest.
3. A future tax liability
The third (and most regrettable) component of your Goldilocks cash kit. If you have a large tax bill looming, make sure you’ve ring-fenced this in cash. This is especially true for significant capital gains tax liabilities, for example the sale of a business, or a valuable investment. Alternatively, it might be if you’ve drawn an exceptionally large dividend, so will have to pay the tax liability via self-assessment, along with a large payment on account. In any event, speak to your accountant, ascertain what the liability will be, and set this money aside, so it’s available when needed (usually the January after the tax year in which the liability arose). You can use instant access savers, or term deposits for this purpose, depending on when it’s due for payment. If it’s a large liability, it’s worth keeping in mind that you can hold up to £2m per person in an NS&I Direct Saver whilst benefiting from unlimited FSCS cover, as it’s the government’s bank.
Conclusions
Of course, making or encashing investments is something that requires personal advice, and that’s what we’re here for. So, if you’re concerned that you may be holding too little - or too much - cash on deposit, feel free to get in touch. We can do a cash audit together and ensure you're in the optimal position
