FOOL'S EYE VIEW
Balancing Cash And Shares

By James Carlisle
September 9, 2002

Striking a balance between stock market investments and cash savings is one of the hardest financial decisions for people to make. Things aren't helped by the multitude of different opinions circulating at any one time and matters are apparently further complicated by the fact that the market is, well, a market -- so that all the different opinions are most likely already reflected in the prices.

It's actually by focussing on this last point that investors can find the true answer to the conundrum. If the stock market is discounting all the views on its short-term direction, then there's precious little point in worrying about them. And, if you do that, you're left simply focussing on the different investment attributes of cash and shares. So the key to balancing your savings and investments is to think hard about what you want them to achieve for you and, most importantly, over what sort of timescale.

Time horizons

As a store of and creator of wealth over the long-term, shares are hard to beat (at least if you take them as a whole as you would, for example, if you invested via an index tracker). In fact, the longer the period that you're looking at, the more likely it is that the stock market will beat cash savings. Over 30 years, for example, shares, taken as a whole, have never failed to win through (according to data from CSFB that starts in 1869).

Over shorter periods, however, the argument for shares is not so strong. They still tend to win (they must, otherwise they wouldn't tend to win over the long-term), but they do so with much less consistency. Nearly 25% of five-year periods have shares doing worse than cash. In the worst of these periods, the one ending in 1974, shares lost out by an average of 16% per year, meaning that they lost nearly 60% of their value relative to cash.

If we take it down to one-year periods, then shares have lost on about 40% of occasions, with the worst being 1974 when shares halved. Down at the one-day level, of course, shares lose pretty much as often as they win and the margin can occasionally be as much as 10% or 20%.

Horses for courses

So it makes no sense to put your monthly salary into the stock market for a couple of weeks until the time comes to pay the mortgage. You might find that you no longer have the money to pay it. Not only that, but you'd have to pay commission on the buying and selling -- costing far more than any likely advantage.

In fact, if you need money within the next year, for a holiday perhaps, then you'd want to save up the money safely in a deposit account -- at least if you want to be sure of getting your week in the sun. You'll also want to keep a cash reserve for emergencies that might crop up over the next few years -- because if you have to fall back on stock market investments, they might no longer be worth what you need them to be.

With money that you're pretty sure you won't need for five years or more, the stock market is probably the best option -- but you still have to accept the fact that it might not work out that way. You often hear people say "five years = stock market, less than five years equals deposit account". "What's so special about five years", you might ask. Nothing much is the answer. It's just that, balancing up the risks, most people seem to think that it's at about the five-year mark, for most people, that the advantages of cash (eg its short-term predictability) begins to give way to the long-term arguments for shares.

But you may or may not be most people. If you can't stomach the 25% or so chance of your investments falling (by as much as 16% per year on one occasion out of 128 and 5% per year on a couple of others), then shares aren't going to make sense for you for money you're putting away for five years. But ask yourself this -- are you really only putting it away for five years? You're probably saying five years because it seems like a long time, but really there's a good chance you mean ten or twenty years.

Shares have lost to cash in only 7% of ten-year periods since 1869. The worst 10-year period ended in 1974, when shares lost out by an average of 6% per year for a total loss of 46% over the period. Bear in mind, though, that shares beat cash by nearly this amount (or rather 4.8% per year) in the average period. For 20-year periods, shares have lost out to cash on just 6 occasions out of the 113 since 1869, or about 5% of the time. Over this timescale, they've never lost out by an average of more than 1% per year.

So, the longer your time horizons for a lump of money, the less squeamish you should be about the risks of the stock market and, the shorter your time horizons, the more squeamish you should be. For most people, the point at which you'll move from wanting to use the stock market, to wanting to be in cash, will be around the five-year mark. But it will depend on various things, most notably how much you can afford to risk the money over that period and how comfortable you feel about doing so.

What to do with the cash?

For your very short-term cash, that you're using to buy your groceries and pay the mortgage, then there's nothing like a current account, into which you'd pay your salary. These do come in all sorts of flavours, though, these days. In particular, some banks, especially the internet-based ones, pay healthy rates of interest on account balances.

For cash that you're storing away for months or even years, you need to ask whether you might need the money at short-notice -- that will determine whether you can lock the money up in a 'notice account'. These can pay higher rates of interest but you might have to wait, 90 days for example, to get at the money -- not much good for an emergency!

Rather than listen to me repeat it all here, though, why not visit the Fool's brand new Savings Centre for more about what to do with your cash savings.