The quiet cost of holding too much cash

A client called last month to say she had moved a substantial sum into a two-year fixed-rate account. The headline rate was the best she had seen in fifteen years, and she wanted to know whether she should move more. It is a reasonable question, and the honest answer takes longer than a phone call.

Cash feels safe because its nominal value never falls. That is genuinely useful for money you will need soon — an emergency fund, a tax bill, a deposit on a property you have already agreed to buy. The trouble starts when cash stops being a short-term instrument and quietly becomes a long-term holding.

What the headline rate does not tell you

Consider £100,000 held for twenty-four months at a headline 4.5%. Before anything else happens, that looks like £9,200 of interest. Then two things happen to it.

Tax comes first. A higher-rate taxpayer with a £500 personal savings allowance pays 40% on nearly all of it. The £9,200 becomes roughly £5,700.

Inflation comes second, and it is the less visible of the two. At 3% over the same period, the purchasing power of the original £100,000 falls by about £5,900. The net position, in real terms, is very slightly negative.

The account did exactly what it promised. It simply promised less than it appeared to.

This is not an argument against cash. It is an argument against holding cash by default, for a period nobody actually decided on.

How we size a cash position

We start from the liability, not the rate. Three questions settle most cases:

• What is this money for, and when? Anything needed inside three years belongs in cash or near-cash, whatever the rate happens to be.

• What would have to go wrong for you to need it sooner? The answer sets the buffer — usually six to twelve months of outgoings, held separately.

• What is the cost of being wrong in each direction? Being early into markets is uncomfortable. Being permanently absent from them is expensive.

A worked position

For a household spending £90,000 a year with a £40,000 tax bill due in January, we would typically hold the tax bill plus nine months of spending — about £107,000 — in instant-access and short-fixed accounts. The rest is invested according to the plan, not according to how the last six months have felt.

The part that is genuinely hard

None of the arithmetic above is difficult. What is difficult is that cash is comfortable precisely when investing is not, and the two feelings arrive together. The families who do best are not the ones with the sharpest forecasts. They are the ones who decided in advance how much cash they would hold, wrote it down, and did not revisit the decision every time a headline rate moved.

If you are holding more than you meant to — and most people are, at least once — it is worth an hour to work out what the position is costing and what it is buying. Usually it is buying something real. Occasionally it is buying nothing at all.