The downside of low-interest rates

Are you holding onto more cash than you really need? During times like these, it can be very tempting to keep your savings close to hand. But it's not the best approach.

The "liquidity trap."

Although keeping your savings in immediate access accounts might make sense, economists refer to this risk-averse behaviour as a "liquidity trap". And it's a situation that's become increasingly common as interest rates have dropped. That's because when monetary policy becomes ineffective because of low-interest rates, consumers prefer to save rather than invest in high-yielding bonds or other investments.

Different levels of risk

When it comes to investing, many people tend to focus on the risk of losing their investment capital either temporarily or permanently. What many tend to overlook is that they may outlive their money or spend it too soon. That's why so many keep their capital accessible, putting up with low returns when they don't need immediate access to so much cash. The problem is, if you keep your money in bank accounts, term deposits and bonds, your investment returns will be so low you won't generate sufficient returns to cover your living costs, capital expenses and inflation in the future.

Rationalising loss

It's true that you take on risk if you allocate part of your capital to growth assets. You'll experience more volatility, but over the long-term, you'll experience higher returns. Nonetheless, it's essential to understand that even when you're keeping your money in a bank account, you're experiencing loss. If a dollar this year buys less than it did last year, inflation has made goods and services more expensive. Your cash will buy less, so you've experienced loss. Even if your balance remains the same.

The effect of inflation on your cash

Over the next three years, the expected rate of inflation is said to be close to 2% per annum. The difference between this figure and cash could be expressed as a negative real interest rate of 2% per annum. Which means that holding onto cash is risky for an investor who doesn't have an immediate need for it. However, it's fair to say that this loss is not as significant as you might experience in other asset classes. Holding onto your cash does give you the highest level of protection. But a mix of assets maximises your chances of achieving your savings goals.

The price of liquidity

Another approach is to move your holding deposits and start making them work for you. If you're earning next to no interest, decide what proportion of your funds you're happy to deny yourself access to for an agreed period and invest in term deposits. You'll get higher interest rates because you're selling your right to access your funds at short notice. Or you may want to consider investing in growth assets with part of your money and keeping a small amount of accessible cash in your immediate access deposit accounts. That way, you spread your risk and make your liquidity work for you.

Too much cash in the bank?

If you think you’re holding on to too much cash, you have plenty of options to choose from. You may have a low-risk tolerance, but this doesn't preclude you from investing part of your funds in growth assets. In fact, it can often be less risky to hold other some of these together with short-term investments that last for a year or less. While these alternatives aren't cash, they can provide far greater protection against loss of spending power. And you can still access them faster than your term deposits.

Finding the right balance

The trick is to allocate the money you want to invest between growth and defensive assets. Our DMG Diversified Portfolio has demonstrated the ability to provide a good level of protection when growth assets fall. But over the long-term, it does give up some of the higher returns by reducing risk. Alternatively, our Dynamic Portfolio allocates 90% to growth assets and will be a more volatile investment, but you'll see higher returns. Whatever you decide, making sure your money is working for you, however you choose to invest, will get you closer to a secure future.

by Gary Lucas.