© ANDY REYNOLDS/CULTURA/CORBIS
What is cash? It’s an odd question but well worth asking for anyone who does their own thinking about personal finance and investment. Cash is notes and coins. It’s electronic digits in an online bank account. Every transaction starts or ends with cash. So far, so obvious. But once you start to dig into the question a little, it can lead you down some interesting avenues.
Money, the theory says, fulfils three functions. It’s a unit of account, a medium of exchange and a store of value. Having read an excellent book on the subject, Paper Promises: Debt, Money and the New World Order by Philip Coggan, who writes the Buttonwood column in the Economist, I think I understand what the theory is saying but it’s not always hugely helpful in describing my own relationship with the pound in my pocket.
Since I’m self-employed, I need an emergency fund to cover everything from an enforced lay-off from work to the demise of our rather aged family car. Aside from the small matter of meeting our everyday bills, this is the most essential role that cash plays in my life.
Classic financial planning suggests you should aim to have three to six months of outgoings salted away for emergencies, which in my case I reckon means about £15,000. It’s a fair sum to have sitting around doing nothing. I guess I could put some of it on 30-day notice and have the rest available instantly, but that wouldn’t ultimately make much difference.
I’m not looking to earn a particular return on this cash; the benefit I want is to know it’s there when I need it. Much the same goes for the cash that sits in my share dealing account. Again, I want to be able to move when the moment comes without having to sell something in order to buy something else.
It doesn’t make sense to look on these cash holdings as investments—they’re stores of opportunity. By keeping cash available for these reasons I am sitting on an open option to respond instantly to any threats or opportunities that present themselves.
Should I expect much of a return just for keeping my options constantly open? Financial options usually come at a cost, so there’s no reason to expect things to be any different in this case. I’m pleased my money isn’t earning me zero but I don’t expect a great deal more than that from it. In the current world of ultra-low interest rates, getting 1.3-1.5 per cent a year isn’t a huge disappointment.
But if you’re holding more cash than you need for a safety net, in effect you’re treating it as a long-term investment from which you should expect a proper return— at least equal to the rate of inflation—and in that case today’s interest rates probably feel like a slap in the face. Should they? If you’re holding cash as an investment, perhaps by tying it up for a fixed term, you’re probably doing so because you like the fact its value doesn’t lurch up and down from day to day as other investments do. It’s an asset you can trust; you know where you are with cash.
But if you could earn a decent return simply by putting cash in the bank then there’s a very strong chance you could be earning even more by investing it in something else, albeit a bit riskier. If that weren’t true, the world’s financial markets would quickly cease to exist and although they’re not currently in the best of health, there’s no sign of them shutting up shop.
Now that returns on cash are so much lower than we’ve been accustomed to— slightly negative after taking inflation into account—the days when open-ended saving could be regarded as a “good thing” have gone. It no longer makes sense. We now have to think differently about the role cash plays. The first step is to be much clearer about how much you really need on tap instead of just trying to pile up money on deposit.
Beyond that, two choices remain: you can either invest anything that’s left once you’ve got your safety net to try to secure a higher return than a deposit account will earn you (while accepting greater risk), or you can use it to reduce your debts on the basis that you’re almost certainly paying a higher rate of interest on your borrowings than you can earn on your savings.
Now, more than ever, cash is a means to an end. Personally, I’m happy to accept a low return on the cash I hold because I don’t expect to be rewarded very richly for adding to a pile of unused options; the rewards only come when you exercise them. That means taking decisions and accepting that I’m going to get a fair few of them wrong. I’d rather deal with that prospect than feel indignant that I can’t earn attractive returns without taking any risk. Even if that was ever true, it certainly is not today.
