Inflation is still eating into cash returns, so look at the alternatives
Current UK inflation rates remain well above interest rates, meaning cash deposits are losing value in real terms. If you have long—term targets, you should consider investing, and there are ways of managing the risks.
Cash savers still under pressure
The UK saver has had a tough time of it over the past decade, and we’ve illustrated before how persistently negative real interest rates have caused pain for cash savers. While investing comes with increased risk, and there’s no guarantee you will get back what you put in, investments have historically outperformed over longer time periods.
However when we talk about investments, it is usually for aspirational purposes: how to become an ISA millionaire, when to stop saving into your pension, or the best growth stocks for the year ahead. This forgets that the majority of us simply cannot afford to put everything into the stock market, just in case there is a large reversal right before you need the money.
At present, if you want to beat inflation the best current accounts barely beat the Bank of England’s (BoE's) 0.75% base rate, let alone get close to the 2.7% recorded by consumer price index (CPI) inflation. For superior low—risk returns, you have to purchase a fixed—rate savings bond, but these often have clauses that cut back the interest received if you need the money earlier than expected. Nevertheless, for a one—year holding period you can make a return of around 1.5% in a fixed—rate bond from providers such as Al Rayan Bank, Paragon and Bank of Cyprus.
Over the short term this seems acceptable in a low—rate environment, although those with balances over the Financial Conduct Authority (FCA) compensation scheme cap should consider diversification. But is this really the best way to keep risk low over the longer term?
If you know you don’t need your savings for a considerable period of time, and also want the flexibility of instant access, then investing in a low—risk investment portfolio can be a sensible option. We always talk about how a diversified asset allocation can reduce your overall portfolio risk, but rarely do we look into the portfolio to explain how those individual components can give you a return that is more attractive than a simple cash deposit.
Looking at IG’s moderate Smart Portfolio, I will try to offer some insight into what types of returns an investor might get from the current underlying exchange traded funds (ETF) allocations (correct as of September 2018).
Investing in a low—risk investment portfolio
Lower—risk portfolios have a sizeable allocation to bonds. These are not designed to give you much capital growth, but instead are in place to offer a way to get a superior income to cash. The whole point of making an investment is that the receiver of your capital should be able to offer you a better return than cash for varying amounts of default risk.
Depending on which asset class you own, this could be the expectation of a small uplift on cash (holding a UK government bond), an enhanced return through credit—worthy corporate bonds (issuers such as Vodafone and BP), or a much higher return on overseas emerging market (EM) issuers or the high—yield market. Owning equity exposure offers the greatest potential upside, but also the highest downside risk.
There will be times when these markets have a wobble, either from interest rates moving higher than the market expects, or from an economic downturn, but history suggests that over time you should expect to get a superior return to cash.
When making investments in fixed income, you cannot guarantee a return but the yield to maturity (YTM) of a bond ETF will give you a good idea of the types of returns you should make if market conditions are benign.
Looking at the current 61% allocation to bonds in a smart portfolio, the blended yield to maturity is 1.3%, through using a very cautious allocation to short—dated UK government and corporate bonds. As bond yields become more attractive, there will be scope to recycle some of that allocation into higher yielding assets. For example, high—yield bonds have a current YTM of 4.9%.
This leaves the equity allocation to try and achieve larger returns. We all know that investing in equities can be risky, but just how risky could this current allocation be when combined with the bonds and a bit of gold?
On our investment platform we provide a simulation of how the current portfolio might have performed over the years. Since 1999 the majority of years has seen positive returns, though 2008 was an obvious outlier. We calculate that this portfolio might have lost 6.6% in 2008, before bouncing back strongly in 2009.
IG Smart Portfolios Moderate (portfolio 2)
Source: IG, September 2018
Unless your market timing is perfect, losses in years such as 2008 are unavoidable. However for long—term investors these should be seen as mere bumps in the road. If your savings are genuinely long—term, the majority of your portfolio can still be in instruments which are safe enough to make a better return than cash and give you that all—important chance of beating inflation’s corrosive effects over time.
This approach limits your downside, while offering the opportunity to participate in global economic growth through making some equity allocations which over the past 100 years have been shown to deliver a return of slightly more than 5% over inflation.