On Monday, we had a question from Moneystepper Savings Challenge participant Cath about investing more in S&S ISAs. I think that the common guidance on saving for short term goals isn’t the best and hence I wanted to explore further in a Q&A episode.
Q&A 32 – Saving Cash In The Short Term – Shownotes
On Monday, we had a question from Moneystepper Savings Challenge participant Cath D.
Cath wanted to know about investing more in a Stocks & Shares ISA. Within her question, she stated that she had savings in an easy access savings ISA with a goal to purchase another flat with a Buy To Let mortgage.
This got me thinking about a subject that we recently approached in our long term investing strategy guide.
Although Cath didn’t specifically ask this question, I think that the common guidance on saving for short term goals isn’t the best and hence I wanted to explore it further in a separate Q&A episode.
Short Term Savings – A Real Life Scenario
Imagine the following scenario. It’s taken from Cath’s question, but I’ve completely made the numbers up for illustrative purposes only.
Say that you have the following:
- A home worth £200k that you have a £100k mortgage on at 3% (annual interest payments of £3k).
- An investment property worth £150k, with a mortgage of £90k at 4%. This property earn £700pm, and after all costs leads to an annual profit (net income) of £3,000 per year.
- Investments in a DC pension of £50k. This is invested earning a total return (interest and dividends – which are reinvested) of 10% per year.
- An emergency fund of 6 months of expenses – £10k.
- Savings for a new buy-to-let investment property. It will be another £150k house with a 60% LTV mortgage. This means that we need to save a deposit of £60k. So far, we have £30k saved and we are keeping this in cash. We intend to be able to save the other £30k in two years.
Traditional advice would be that you should keep the £40k (£30k savings for house purchase and £10k emergency fund) in cash. I would disagree.
Firstly, let’s consider diversification. At the moment, we have with a total net worth of £100k equity from your home, £60k equity from the investment property, £50k pension savings and £40k in cash – total of £250k.
Depending on whether you assign the loans to the specific property assets, or generally across your portfolio (I’d recommend the latter) you will either say you have a split of 64% property, 20% equities and 16% cash, or 80% property, 11% equities, 9% cash.
You then need to look at these splits to determine whether you think these invested percentages are appropriate to your risk tolerance, and more importantly, whether you have a bias in your investment split towards asset classes which are providing higher returns.
In my opinion, the split between property and equities here look fine from a diversification standpoint. Whether the next investment should be property rather than more equities may be a harder question to answer.
Are We Losing Out By Holding Cash?
However, the split between equities and property here isn’t my issue – my real problem is with the cash!
Let’s say rather arbitrarily that Cath’s property investments return 15% per annum and her equity investments return 10%.
Generally, the property investments will be more volatile as they depend on capital appreciation on the property, the overall housing market, tenant demand, tenant behaviour, tax regulation, policy changes and many other factors. However for this, she is rewarded with greater returns.
So, let’s say that Cath’s investing plan is to wait until she has £60k in cash to buy another property.
Starting today, she has £40k in cash (£30k savings for deposit and £10k emergency fund). If this is invested in her easy access cash ISA, she may obtain a 1% return (guaranteed). We’ll assume that she puts in another £1,250 per month, so that she’ll have the £60k saved in two years’ time.
At the end of the two years, Cath would have £70k in the cash account, and she would have earned £1,092 in interest.
What’s The Alternative?
Alternatively, she could have left £2k in cash to cover almost all “day-to-day” emergencies, and everything else she could put into equities earning an average (non-guaranteed) returns of 10%. If she needs more emergency funds, then the equities can be liquidated to cash in a matter of days.
In this scenario, if no emergencies occur for over £2k (which is the “norm”), she would have the £2,040 in the cash account, and £78,899 in the equities account. Therefore, she would be almost £10,000 better off in two years.
Obviously, the big difference here is risk, as this is the average scenario. The questions an investor would need to ask themselves:
- What happens if I need to liquidate my investments for emergencies?
- What happens if the market only increases 5% in the two years? Or 2%?
- What if the market falls 5%? Or 10%?
- How likely is this to happen?
- How would that effect housing markets?
- What would it mean for my overall strategy?
You can find a deeper example in the investing guide, which looks at these questions in more detail. The key analysis is mapping what would happen in different markets. However, my conclusion is always the same. “Cash” is never an investment, but only a store of value. What you need to work out is if you really *need* to store that value.
Short Term Savings – Conclusion
Yes, if you need to pay the rent next week and you have £500 to pay a £500 bill, I would never recommend investing it. In this scenario, you need to store the value, and you should be willing to forego investment returns for the guarantee of making the payment.
However, when looking at your overall investment position, and your overall returns, I think that many people are over-weight in cash when “saving towards another investment”.
Remember, “Investments” aren’t just measured at one point in time.
Say that over the course of 5 years, you earned 1% on your cash and then you bought a property so that in year 6 you had a 20% return on your cash. £10,000 would turn into £11,500 after the 6 years.
If you’d have earned a lower 5% on your investment over the 6 years, you would have £13,400 at the end of that period.
Conclusion: whilst it is vital to think about diversification and ensuring that your investments are protected on the downside, you should equally think about your overall net worth and related investments in order to maximise your returns every year.
This is quite a controversial topic and so I’d love to hear your thoughts on the matter. Let me know in the comments below.
Moneystepper Savings Challenge
If, like Cath, you want to join the Moneystepper Savings Challenge, it is only free to join until 31st October 2015.
So, join today if you want to achieve your financial dreams.
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