I promised my twitter followers something special:
Been doing some number crunching on UK returns – with a very surprising result. Watch this space…
— Young FI Guy (@YoungFIGuy) August 16, 2018
So here it goes. It’s 1 January 1989, the Soviet Union still exists, Kylie Minogue has just conquered the charts with her debut album and Young FI Guy isn’t even born yet. Here’s the question: what would you take: 20 years of cash returns or 20 years of global equity returns. A no-brainer right?
Quite remarkably the return on both was almost exactly the same (although with significantly different journeys!). Two months later, in February 2009, the cash return would overtake the equity return. That’s right, over a twenty year period, cash beat equities.1
What the hell?!
Financial economics says this shouldn’t happen. Over such a long period, higher risk assets should deliver higher returns. But it can happen. As Monevator recently pointed out: Taking more risk does not guarantee more reward. That’s because:
Risk means that more things can happen than will happen.
When cash was king
It’s easy to forget, but cash used to give a pretty great return:
Throughout the 90s and early 00s, cash paid out significant real returns. And we’re talking risk-free returns here. The return shown above is from the Building Society Association. This is the average interest rate you’d get from popping to your local building society and opening a savings account. No TIPS ladders, no money market shenanigans. Simple deposit savings. Completely risk and stress-free.2
Mr YFG’s journey – growing a princely sum
This result, though surprising, was instinctive for me. I grew up saving a lot. By the time I was 16 I had saved up 1,000s of pounds through birthday and Christmas gifts and working. I fondly remember double-digit interest rates up until the late-00s. Children’s accounts could have incredibly high rates. I very much rode that cash returns chart. But then the financial crisis hit.
Knocked off the throne
I suspect some of you will be screaming at your screens right now: “you’re not telling the whole story!”
Alas, you are right. Because since the financial crisis, interest rates have plummeted:
[Note: the BSA average Building Society rate data stopped in 2007, to create a longer dataset, I’ve combined this with the Bank of England average 1 year Fixed Bond interest rate from 2008.]3
I’m not a banking expert, but from what I gather there are three reasons why this happened:
- Quantitative Easing and Funding for Lending – these policies made it very cheap for financial institutions to borrow money. It dramatically reduced the need for customer deposits to fund lending.
- In addition, the Bank of England drastically cut the base rate, further reducing the cost of borrowing.
- The financial crisis caused a wave of consolidation in the market, reducing the competition for customer deposits.
This had a huge impact on returns:
Generally speaking, real cash returns have been negative since the financial crisis. Only popping up into positive territory for brief periods.
The full story
So let’s fast forward 10 years, how does our choice between cash and global equities stand after 30 years?
To put it mildly, the equities have usurped the throne. At the 20 year stage, you’d have roughly doubled your money (in real terms) with both cash and global equities. At the 30 year stage, you’d have a 550% real return with equities. Over the last ten years, you’d have actually lost money on your cash (in real terms).
In other words, if you had held on to tried and tested cash, you’d have massively lost out. This is one of the reasons I bang on at young people about how important it is to start investing as soon as possible. Those sitting out there with all their money in 1% Cash ISAs are getting poorer. If that’s you, I strongly recommend to close this window and open a broker account right now (look at this link on how to do it).
Let’s have a think about what we can take away from all this:
- Even over very long periods, risky assets might now give you a better return than risk-free assets
- Cash has historically been a great investment asset
- But right now, it isn’t
- That might change, but if you are currently sitting on piles of cash you are losing money
- But even globally diversified equities are highly volatile, there’s no guarantee of high returns
I have fond memories of my old cash accounts. And I feel it is a shame that cash isn’t the investment it once was. Building societies were a great way to get individuals to start saving for their future. But times have changed. Am I the only one who is nostalgic? I’d like to know if you are too, or if you think I’m being a sentimental fool.
All the best,
Young FI Guy
1 Cash returns data sourced from BSA and BOE. 1989-2007, from BSA 2016/17 yearbook, “Building Society Average Gross Share Rate“. From 2008, BOE “Monthly interest rate of UK monetary financial institutions (excl. Central Bank) sterling fixed rate bond deposits from households (in percent) not seasonally adjusted” – ID:IUMWTFA. These returns are gross, as in before tax. Equities data from MSCI: MSCI ACWI, GBP, Index Gross. Unlike the cash return, you would not have been really able to get this return as I don’t think an index tracker has tracked this index back to the 80s – besides you’d have fees and tax to pay. In that respect, the equities return is overstated by more than the cash return! Inflation data is monthly CPI from ONS: Series ID: D7G7.
2 Datasets for interest rates periodically changed. Prior to 1989, Building Societies were somewhat enforced in the interest rate they had to offer. In the late 80s banking was substantially deregulated giving building societies greater flexibility to set rates (and demutualise). I tried to find the best fit with the BSA data from the various BOE data series. I went for 1 year fixed bonds as that seemed to be ‘the closest fit’.
3 This post is another example of why I don’t like the term “risk”. Risk, as defined by volatility, isn’t particularly helpful to individual investors. I prefer to think of three different types of risk: inflation risk, capital risk and shortfall risk (link).