The cash conundrum: dealing with the cruelest tax

Anyone with even a passing knowledge of the economic landscape of the last decade won’t need reminding that the value of investments can go down as well as up.

One response to the possible volatility of financial markets would be to put all your cash in the bank as, in theory, this should be protected by a national compensation scheme.

But there is a subtle hazard locking your cash up in a deposit account: inflation. It is not known as the 'cruelest tax’ for nothing. If the interest rate on your savings fails to keep up with inflation then the spending power of your money will fall.

Although the merits of cash as an asset class look weak, most of us will still want to have some tucked away for periods of unemployment, unexpected bills, holidays or home improvement projects. Even if you are ready to put your money to work in the market, you may wish to have cash available to take advantage of new investment options.

In terms of an emergency fund, a good rule of thumb would be to have the equivalent of at least three months’ salary squirreled away.

Maintaining some liquidity in your portfolio is also a good idea. Without it, you could be left behind by fast moving markets and fail to make the most of opportunities as and when they arise.

There are even more benefits for investors keeping cash easily accessible. Having the reserves to be a cash buyer means you can take advantage of more opportunities than if you have all your money tied up in other assets.

Making the right choice with your cash

The question of how much of your portfolio to retain as cash is a matter of personal preference but anything upwards of 5 per cent is probably a reasonable sum.

If the markets are becoming more volatile, it might make sense to increase the cash element of your portfolio. This could provide you with some protection against market losses and to be in a position to snap up undervalued shares ahead of a future recovery.

Where should you hold your cash?

The process of finding the best available interest rates has become increasingly simple, with the emergence of several price comparison websites. Sites such as MoneySuperMarket give you the run-down on which of the various UK savings providers offer the most attractive rates.

This is relevant when central bank interest rates remain close to record lows and governments are effectively printing cash in an attempt to prop up a tottering economic recovery. Despite falling significantly, the retail prices index (RPI) measure is still running, at least at the time of going to press, at just less than 3 per cent.

The only way savers can hope to secure any sort of real return is to tie their cash up in a long-term savings account, but this could prevent you from accessing your money when you need it.

With the generous annual ISA limit of £20,000, it’s possible to reduce your tax exposure by putting your money in a cash ISA, which makes interest payments exempt from taxation.

Safety first with cash

The level of protection for UK savers has been stepped up since the onset of the credit crunch and collapse of Northern Rock in 2008. Under the Financial Services Compensation Scheme (FSCS), all UK regulated current and savings accounts and cash ISAs are protected up to a total of £85,000. If your bank or other savings provider goes out of business, the scheme will compensate you for any loss below this threshold.

When cash is sovereign

Although the value of cash can be eroded by inflation, in a deflationary environment where prices are falling, the opposite is true.

Cash is then among the safest investments you can make because as prices fall, its buying power increases. If deflation strikes it’s also a good idea to pay down debt, to avoid losing any of your increasingly precious pounds and pence to interest payments.

Investment Edge

This article first appeared in the April 2018 issue of Investment Edge Magazine, a digital magazine packed with tips and advice for investors.

EQi does not provide investment advice. Investment Edge is provided by Shares Magazine and is the author’s view and is not the view or opinion of EQi and EQi accepts no liability for any loss caused as a result of the use of this information. The opinions expressed are those of the author at the time of writing and should not be interpreted as investment advice.