Cash isn’t as risk-free as it seems

Risk means different things to different people. Guy Beck spells out the unexpected damage to your wealth from holding cash and eschewing stock markets.

Trying to explain what ‘investment risk’ is in a short note is a challenge, as it means different things to different people. 

To a person with little knowledge of investing, putting money into the stock market can feel like a risky thing to do. After all, they have probably been told, or read, that stock markets are volatile and are therefore ‘risky’ and not for the faint-hearted. 

With bank deposits paying a decent return in 2024 compared to recent years, they may be tempted to remain in cash. 

Reckless conservatism

To someone who is a more experienced investor and has weathered some tough stock market downturns but has been rewarded with strong overall returns from dividends and share price rises, being invested in the stock market feels less risky than the reckless conservatism of placing bank deposits. 

The problem here is one of time-frames and inflation. In a year’s time, one can be more certain of what your cash will buy you than you can of your stock market investments. 

In 20 years’ time, the risk is that you do not have enough in your cash pot to support all the lifestyle dreams and choices that you had hoped for. This could be described as ‘goal risk’ and one that all investors should be focused on.  

The chances are that, over longer time frames, cash becomes the riskier asset, as it is less effective at delivering growth in purchasing power than stocks. 

Using long-term US data from 1926 to 2023, cash has delivered around 0.3% per year above inflation. US stocks, on the other hand, delivered a little over 7% per year above inflation.

Purchasing power

In purchasing power terms, over this 98-year period, 100 US dollars grew to 135 US dollars for a holder of cash, whereas for a holder of US stocks, this turned into 85,300 US dollars.

In fact, cash suffered a 50% loss of purchasing power from May 1933 to December 1951 and it took until October 2001 to recover! That is risk.

Since January 2009, cash has lost 25% of its purchasing power, yet this is only half of the 50% fall in value of the 1930s and 1940s. 

Alternatively put, 100 US dollars held in cash in August 1989, is still only worth 100 US dollars today, whereas if it had been invested in equities, it would be worth over 1,000 US dollars in purchasing power terms.  

Investing in stocks can be risky from an emotional point of view, as they suffer severe peak-to-trough falls. For example, US stocks have fallen more than 50% on four occasions since 1929, with the worst fall of almost 80% – after inflation – being the Wall Street Crash that started in 1929 and bottomed out in 1932. 

It would be hard for most investors to suffer such egregious losses and stay focused on their long-term plan. Yet, those with the emotional and financial capacity to stay invested recouped these losses by the end of 1936.  

More recently, the ‘dot.com’ crash of the early 2000s took US equity investors nearly 13 years to recover from. Even this simple example illustrates how multi-faceted risk is. 

Global diversification

Investors need to be aware not only of short-term volatility, but also of goal risk, which is materially influenced by inflation risk during the investor’s investment horizon, and the prolonged periods that portfolios can potentially be under water (drawdown risk) once inflation is accounted for. 

Helping investors to balance – and where possible mitigate – these risks is an important part of an adviser’s role.

Global diversification to reduce the impact of market specific falls can help, as may incorporating different styles of stocks, such as smaller companies and value stocks and potentially other asset classes such as global commercial property. 

Allocations to shorter-dated, high-quality bonds can help to dampen short-term volatility and inflation-linked bonds may help to mitigate the risk of inflation to some degree.

Understanding what risk really means to you is an integral part of the financial planning and investment process. Your adviser should help here.

‘Risk surrounds us and envelops us. Without understanding it, we risk everything and without capitalising on it, we gain nothing.’

Breakwell and Barnett.

Guy Beck (right) is a senior financial planner with Cavendish Medical, specialist financial planners helping consultants in private practice and the NHS 

The content of this article is for inform­ation only and must not be considered as financial advice. Cavendish Medical always recommends that you seek independent financial advice before making any financial decisions.
Levels, bases of and reliefs from taxation may be subject to change and their value depends on the individual circumstances of the investor. The value of investments and the income from them can fluctuate and investors may get back less than the amount invested.