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Should I Open a 5% Savings Account or Invest?

www.gradragstoriches  Save or Invest?

Cash is King

With savings accounts now offering 5% interest rates, why would anyone consider investing in stocks?

Cash offers stability and a sense of security; investing offers risk and volatility. In this blog, we investigate whether we should be focusing on building up cash savings at high interest rates instead of investing.

Cash for Short-Term Needs

Before diving into the reasons why savings accounts may not be the best long-term deal, it is essential to recognise the value of cash for covering short-term needs and as an emergency fund. High-interest savings accounts currently offering over 5% annual interest provide a safe and accessible option, as do Premium Bonds. Your emergency fund could even be held in a cash LISA gaining 25% additional returns - as long as you are aware of the drawbacks (Press here for more details on LISA).

Investing is inherently volatile which increases the risk of loss in the short term; the value of your investment account can go up a lot in the short term, and down a lot in the short term, which makes it less suitable for short-term objectives. Imagine the £20,000 you have saved suddenly reducing to £17,000 just as you are about to place a deposit on a house….

Fear and Greed

History shows that financial behaviour is highly sensitive to interest rates. When interest rates are low, individuals often seek higher returns in riskier assets like stocks and bonds. Conversely, higher interest rates lead to reduced exposure to riskier assets.

Since the financial crisis in 2008, the choice between saving cash and investing has been easy. Prolonged periods of historically low interest rates left savers grappling with meager returns of 1% or less, however, the financial landscape has transformed over the last 12 months with savings accounts now offering over 5% interest rates.

Short-Term V Long-Term

In the 100 years spanning from 1922 to 2022, over a 1 year period, cash outperformed stocks on approximately 31 occasions. In 2022, stocks experienced an 18% decline, bonds dipped around 13%, while cash offered a nominal return of 2% - the bitter memory of such a decline lingers for investors.

(Note: the real interest rate is the nominal interest rate minus the inflation rate).

But, the longer the time frame, the less chance cash has of beating the returns on stocks. Over 10 year periods, cash beats stocks 16 times, and over a 20 year period just once. Over the last century, stocks have consistently outperformed cash over extended periods.

Consider any 25-year time frame within the past century, and stocks have always delivered superior returns. This outperformance means that, on average, stocks have produced returns approximately 1281% better than those of a similar cash holding over a 25-year period. This is what that difference looks like:

Over the long term, stocks prove to be the optimal choice for those with saving goals extending beyond a decade. Looking at the S&P 500 for the years 1993 to mid-2023, the average annual stock market return for 30 years is 9.90% (7.22% when adjusted for inflation). However, the stock market's inherent volatility makes it less suitable for short-term objectives.

Even When Interest Rates on Savings are High?

Returns on stocks have historically been higher than on cash returns even when interest rates have been high. Cash actually has lower expected returns than stocks in most environments since cash does not command a risk premium. Stocks are expected to earn a premium above and beyond the return on cash to compensate investors for taking risk. Based on this we should expect that when interest rates increase, expected returns on stocks also increase, and this is exactly what we see in the data:

Five-year returns on stocks, sorted on their starting interest rates, increase with higher starting interest rates. This suggests that, as theory predicts, the risk premiums for stocks above cash are persistent even at higher interest rates.

This is important; even if interest rates are high, expected returns are being left on the table when you hold cash.

Preparing for the Future, Not the Past

The saying, "Generals are always preparing to fight the last war" serves as a reminder that we often plan based on past events, when we should adapt to what lies ahead. A case in point is 2022; staying in cash throughout that year would have meant missing out on the substantial gains witnessed in 2023, with returns up 17%. Therefore, we must ponder how to decide between holding cash and investing.

If you are considering holding onto cash until the market experiences a dip and then investing in stocks, be cautious. Research has shown that consistently investing a lump sum often outperforms attempting to time the market by buying the dip.

The Impact of Inflation

We cannot overlook the impact of inflation on asset values. Inflation eats away at the spending power or the value of cash, and it also erodes the real returns of stocks.

When a bank offers a 5% interest rate but inflation stands at 10%, the real return is a negative -5%. So, something you could buy a year ago for £1 now costs £1.10, but your savings account now only holds £1.05. UK inflation is currently running at 6.7%.

This principle applies to both cash and stocks, hence, the crucial question is which asset is better equipped to outpace inflation in the long term?

Data from Schroders illustrates the likelihood of cash and large company stocks beating inflation over various time periods. The results reveal that over any given month in the past century, cash and stocks had approximately a 60% chance of outperforming inflation. However, as we extend the time horizon to five, ten, twenty, or fifty years, stocks consistently outshine cash:

Save or Invest

While cash may offer attractive interest rates in the current environment enticing long-term investors to hold cash rather than stocks, the choice between cash and stocks hinges on your investment horizon and financial goals.

For long-term objectives, stocks have historically been the superior choice, outpacing cash and inflation. However, for short-term goals, cash provides stability and security.

Ultimately, the key is to align your investment strategy with your specific time frame and objectives.


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