The behavioural comfort of cash – is cash always king?

Recent stock market volatility, soaring commodity prices, and uncertainty over what the future may hold are giving investors much to think about right now. For many, the idea of investing given the prevailing geopolitical backdrop may not appeal but is holding cash really the answer?

We’re currently experiencing a sustained period of much higher inflation than we have become accustomed to. Combine this with low interest rates, and cash deposits are losing their purchasing power quicker than over the last decade. It is therefore more important than ever to consider how we use the cash we hold as it could instead be put to work to attempt to preserve and grow its value through investment. This, however, is easier said than done due to the comfort that cash provides.

Investing offers no guarantees, and there is a risk of investments being worth less than what you started with. However, done sensibly, you can reduce some of the risks and investing has the opportunity to provide above-inflation returns over the long term.

So, why do we find comfort in holding cash?

While it is sensible to have some highly liquid assets, such as cash, for short-term expenditures and unexpected situations, experience shows that people hold too much of it relative to their other investments, income, and lifestyle.

The ‘familiarity bias’ can be helpful in understanding why we might prefer to hold more cash than we need. This phenomenon describes how people will often opt for more familiar options over potentially new alternatives. Given the day-to-day interactions we have with cash, it obviously feels more familiar than various types of investments. A further explanation can be the ‘certainty effect’, where we favour certain outcomes over possible ones¹. When we invest in the stock market, there are no guarantees about the returns, whereas cash deposits are usually seen as very certain.

When we have money put aside for a goal or a rainy day, or surplus cash, the default and easy option is to place it into a savings account. Anything else, such as investing, requires an active cognitive effort.

The reality of the situation

To put inflation into context, over the past 10 years, inflation as measured by the Consumer Price Index (CPI), has averaged around 2% per year. This may sound insignificant, however the effects over time can seriously dent your goals. For instance, if you had deposited £100,000 in a cash account earning interest² in December 2009, the actual value of those savings at the end of December 2021 would be around £109,392.

However due to the effects of inflation, the real value, or the value in terms of the goods and services you could buy from 2009, would be around £83,645. Note that past performance is not a guide to future performance.

The reality is that CPI likely underestimates your personal inflation rate, which can often be much higher for investors, depending on their spending habits. Certain items are more exposed to inflation, for example air travel costs have increased by 16.2% over 2021, cinema, theatre, and concerts by 9.5%, and buying and fitting boats by 6.6%³. This means that if you engage in these types of activities or products, your personal inflation rate is likely greater than CPI. So, while we find comfort in holding cash because of its certainty, this is illusory.

How can I find this comfort elsewhere?

So, comfort comes at a cost, and it is important to weigh up the emotionally-valuable comfort of holding cash against the reality that it can have detrimental consequences for our long-term financial goals. To reduce the uncertainty aversion that many of us experience in the context of getting invested, and increase our comfort, there are a few steps that can be taken.

• Increase your understanding of investing over the long-term – the more you know, the less uncertain you will feel.
• Invest in a diversified portfolio, in line with your risk tolerance and capacity.
• Manage your expectations – we know that investing carries risks, which can feel unsettling in the short term due to not knowing exactly when the value of our investments may rise or fall. However, if you get comfortable with expecting short-term losses and take comfort in the very likely long-term gains, it will be a more positive experience.
• Reframe your mindset – while we think cash helps meet our goal of financial security, it can actually make it harder as the value is eroded and we need to save more.
• Be reassured by knowing that you have a safety blanket of cash reserves, while reminding yourself that anything above that could be used to reach your financial goals.

In summary, seeking comfort by holding more cash than we really need to is a behavioural tendency that affects us all. This might impact some more than others, and given the backdrop of high inflation rates, it is crucial to confront this illusion of comfort and realise that cash, while necessary, isn’t always king.

We don’t offer personal investment advice so if you’re unsure you should seek that independently.

Funds are designed for the long term so you should only consider them if you can stay invested for at least five years.

These are our current opinions but the future, as ever, is uncertain and outcomes may differ.

Read the Assessment of Value report [PDF, 3.2MB] for funds run by Barclays.