In This Chapter
Understanding why you need cash in your portfolio
Staying protected
Facing the evil truth about interest rates
You can easily think that stocks and shares are the only really challenging area of the investment business, and the only area that needs a lot of explaining in this book. But tens of millions of investors actually prefer to place their faith in cash investments of one sort of another.
And a good thing, too. As the saying goes, you never miss your water till the well runs dry, and lots of investors were left feeling very illiquid indeed when the stock markets failed to perform in the credit crunch of 2007–2008. The problem wasn't just that their equity investments weren't doing the business for them: people who hadn't set aside enough cash provisions to tide them through a difficult period found themselves suddenly running into quite serious problems with their banks, which were starting to take a tougher line on everybody's finances and had developed a distinct tendency to downgrade the credit ratings of those who hadn't got much in the way of liquid assets.
Meanwhile, people who put their money into safe but boring cash investments were enjoying investment returns that dwarfed what the stocks and shares investors were getting. Cash doesn't often beat equities over a prolonged period, but this has been one of those times.
Even the biggest stock market bull needs to invest in cash as well – no matter whether you're doing this to diversify your risks and protect yourself from stock market downturns, or whether you simply need a place to keep some of your cash between selling a stock and buying something else.
Being able to park your money in cash from time to time is one of the things that make you different from a professional fund manager. A fund manager doesn't have the option of keeping large sums of money in cash, the way you do – or not for long periods, anyway. If he does, he's in breach of his fund's rules that basically require him to stay invested all the time, with only short breaks in cash. (Things are a bit different for hedge fund managers, who can do anything at all; see Chapter 15.) But for a more conventional manager, the minimum-cash rule applies.
The reason this requirement is a problem for a fund manager, but good news for you, is that being able to take your money out of stocks and into cash from time to time is probably your best hope of beating the market! Doing so allows you to 'time the market' (if you're lucky and/or very skilful) by picking your entry and exit points carefully. During the bear market (see Chapter 4 for what these are) of early 2008, I shifted most of my investments out into cash, which allowed me to wait until the market had dropped quite a lot before I bought back into my shares. Timing the market precisely isn't easy, though. I'd have been in trouble if I'd been wrong about my suspicion that the market was about to fall steeply, because if shares had risen instead of falling then I wouldn't have gained anything at all – instead, I'd have been forced to buy the shares back for more than I paid for them.
For most people, the main point about having some cash investments is that they bring in interest instead of capital gains. The question is, what sort of interest do you need, and how do you intend to go about arranging it?
That probably sounds like a stupid question. But you need to be clear about two major issues: tax and time.
Most people don't spend much effort thinking about the tax on cash investments. Unless you've got a fairly sophisticated portfolio and a very astute financial adviser, the money probably comes to you with the tax already deducted at source. You've probably seen the annual statements that the bank (or the building society, or whatever) sends you in the spring for the end of the tax year on 5 April. The statement tells you the gross amount your savings have earned during the outgoing financial year, and the amount of tax that's been deducted and paid straight to HM Revenue and Customs. All you ever see is the net amount.
The chances are that you stick your statements in a drawer and forget about them because nobody ever asks you for them. But steady on. The tax that's deducted at source is calculated at the standard rate of income tax, currently 20 per cent. That's all very well as long as you're not paying higher-rate tax on either your earnings or your savings. But if the combined weight of your salary and your interest income takes you over the threshold and into the higher band, then HM Revenue and Customs makes an additional deduction – either through your PAYE (Pay As You Earn) or through your twice-yearly tax bill if you're not a full-time employee. HMRC knows who you are because you provided the bank with your National Insurance details when you first opened the account.
The main exception to all this is if you don't pay any tax at all – for instance, if you're a child or a very low earner. Your bank or building society supplies you with Form R85 on request, which is a declaration that you're ineligible for tax and want your interest paid to you gross instead of net.
Some investors, especially wealthier individuals, find that being asked to pay income tax at the higher rate (currently 40 per cent) spoils the game. For these people, the attractions of having an income from cash investments are somewhat diminished – especially when you remember that if they invest in stocks and shares instead they could get an annual exemption of around £10,000 on all their capital gains. And that even if they had to pay capital gains tax (Chapter 5 has the lowdown on this tax) on what they made above that limit, it would still betaxed at only 18 per cent, which has been the standard capital gains tax level since spring 2008.
And, further, that if they choose to invest their money through tax-efficient ISAs, they don't have to pay any capital gains tax at all under any circumstances, although some income tax is payable on any dividends their shares pay out.
Tip
Cash investments aren't for everyone. Before you automatically assume that cash is the right way forward for you, make sure that it really suits your lifestyle.
How long can you really afford to lock up your money for? Consider four basic questions:
Are you just keeping a few thousand pounds in a current bank account so that you can feel secure in the knowledge that it's there if the car's gearbox goes bang tomorrow? People tend not to worry so much these days about having ready cash for such purchases, because credit cards and convenient bank loans have given us easy ways of plugging a gap of a couple of months in our finances. (Although we might like to add that these avenues haven't been quite so easy or so convenient since the credit crunch of 2007 forced the banks to rethink their easy lending policies.)
Are you trying to build a nest egg over the long term, by making regular payments into a savings account to fund a big event later in your life? Paying for your children's university education, a holiday home, or a world cruise? A 'notice' or 'term' account is obviously the way to go.
With a notice account, you know that you aren't able to withdraw money at less than (say) a month's notice – or, if you can make a withdrawal, you either pay a charge or lose a chunk of the higher interest that these accounts normally pay.
Can you positively guarantee that you don't want to access your money at short notice? And are you willing to lock up your money for a long period? If so, two obvious options are open to you.
One option is to take advantage of the National Savings & Investments bonds available from your post office, which often beat anything you can get from banks or building societies. Best of all, NS&I interest is paid tax free.
Another option is a cash ISA, which builds your nest-egg in a tax-free environment for as long as you like. You can pay in a limited sum every year (£3,600 per annum at the time of writing) and you can get at your money at any time.
Are you saving to build a nest egg for a child? If so, consider child trust funds, which allow parents or grandparents to make regular payments into a tax-efficient growth fund, and either to claim the tax relief for themselves or to allow it to be paid back into the fund. The fund can be self-administered, or the management can be left to a professional; either way, the fund attracts two cash payments of £250 from the government at two separate stages of the child's life. (Additional government payments are available for children from deprived backgrounds) Then, when the child reaches the qualifying age (currently 18), the money in the child trust fund can be 'rolled over' into a tax-efficient ISA, even though it's probably much larger than the normal annual contribution limit for an ISA. More details are available at
www.childtrustfund.gov.uk.
Note
You have a lot of choices available, and most of them involve looking closely at your own lifestyle and figuring out what's right for you. If you're like most people, you decide you need a little of everything. You may, for instance, want to have £5,000 on instant access, another £20,000 or more in notice accounts, and the rest invested in cash ISAs and bonds for the longer term.
I probably ought to say that 'bond' is one of the most over-used words in the financial market's vocabulary. It can mean anything from the premium bonds you buy in the hope of a million-pound win, through to the 'guaranteed income bonds' that your building society offers (see Chapter 19), and of course the 'proper' kinds of bonds, which Chapter 6 covers and which are in a different league entirely because they carry risks and rewards that are hard to predict. That's not what you want for your cash investments at all!
An interest rate return is only worth having if it beats the inflation rate. I can well remember my father, back in the inflationary 1970s, discovering to his surprise that borrowing the money for his new car was cheaper than saving up his money for two years and then paying cash. That's because the interest rate he had to pay was below the inflation rate (what's called a negative real interest rate).
Negative real interest is a rare thing, of course, and its occurrence doesn't do anybody any good because it destabilises the whole of the financial system. If inflation is running at 10 per cent, you aren't going to lend £1,000 to your bank if that amount's only going to bring you a 5 per cent interest rate return, because this time next year you'll need £1,100 to buy what your £1,000 buys you today, whereas your 'increased' cash pile's only worth £1,050!
But then, you aren't so stupid as to sign up for a deal that delivers less than inflation, are you? Well, perhaps. If you buy a fixed-interest government bond that gives you a fixed 5 per cent for the next five years, you may be a bit perturbed if inflation suddenly picks up to 10 per cent. And if you lock up your money in a deposit account that pays you a variable rate, you may be a bit annoyed if the bank lowers the rate while still locking you in – or worse, if it moves your high-yielding account onto the back burner while you aren't looking, so that the interest rate quietly fades away. These things shouldn't happen, but they do.
The bottom line is that you really do need to stick a finger into the wind when you look at an interest rate, to try to measure how fast the inflation rate is moving. You may be surprised at how rare a real interest rate of more than about 2.5 per cent actually is.
That's not to say you're necessarily better to put your money into stocks and shares, of course. As investors found out in the first half of 2008, when the stock market dropped by nearly 20 per cent, many things are worse than a 2.5 per cent real interest rate!
Warning
If you have a conventional account with an old-fashioned broker who handles your affairs for you, the chances are that you're able to use these interludes to make a bit of interest on the side while your money's out of the game. But the situation isn't so good if you're running a tax-efficient self-select Maxi ISA (Individual Savings Account; see Chapter 1 for more on these) instead.
Note
Sad to say, you probably aren't able to get much interest on your money while it's sitting in a share ISA provider's trustee account waiting to be redeployed. They don't offer much interest, if any, because they know full well that the ISA rules don't exactly encourage you to swap your money out of the ISA and into a bank at will. The thing is, every in-payment to an ISA counts as part of your annual ISA contribution quota, even if you've only parked it somewhere else temporarily. So if you move, say, £1,000 into the building society and then back into your ISA, and then repeat the action seven or eight times in a year, you use up all your annual ISA entitlement and eventually the ISA provider refuses your money because you've exceeded your quota.
Where can you find price information on the returns you can expect to get from your cash investments?
Almost anywhere, is the answer. The Sunday papers are full of listings that tell you which are the top-performing deposit accounts this week. They don't tell you about accounts that have been closed, or about deals that are now off the table – unless they're talking about National Savings bonds, where they often give you figures that relate to closed issues.
Just for once, the Financial Times is probably not the best place to go looking for a listing of interest-bearing accounts. Because its emphasis is on business-related matters for professionals, it tends to pass over the small private investor. The main exceptions are the FT's Weekend section, and the occasional supplements it publishes for wealthier investors.
The Daily Mail and Mail on Sunday, the Times and Sunday Times, and the Daily Telegraph and Sunday Telegraph get the mix about right. You'll find comparison tables that set out the best buys, the lowest rates, and details of where to get more information.
You can also get excellent advice and information from price comparison web sites such as www.comparethemarket.com, or from so-called fund supermarkets and portals like Interactive Investor (www.iii.com) that will present you with a huge range of options, together with details of the special conditions that often apply to these products. (You'd be surprised at how often an attractive 'headline rate' is only available for the first twelve months, after which the interest rate heads straight back down to something much less attractive.)
But for many investors, the best and most comprehensive resource for making price comparisons is still the good old Motley Fool. The UK incarnation of the Fool, at www.fool.co.uk, is set up especially to meet the needs of British investors (as distinct from the parent site www.fool.com, which is aimed primarily at Americans).
In theory, you shouldn't any longer have a problem understanding the interest rates banks charge when they lend to you – or offer when you're doing the lending and they're the borrowers. The regulators thought they'd done the job years ago when they required all lending institutions to print their offered rates as Annual Percentage Rates (APRs). But they were wrong, because the banks and lending institutions soon discovered a hundred different ways to tweak the figures, for better or (usually) for worse.
In theory, the APR wasn't a bad idea. It was supposed to tell you how much your loan would really cost you over the course of a year, by adding in the cost of any up-front fees to the nominal cost of the loan. That sounds simple, doesn't it? And to be honest, the APR's still the best way of comparing the rates from two lenders.
So what was life like before APR? Well, back in the bad old days, if a lender intended to charge you 10 per cent a year, he could tell you he was going to do that in any one of three ways:
And all of them produced exactly the same result. So guess which way he chose to sell you the loan? The first way, of course, if he thought he could get away with it, because you'd think you were only paying seven-point something instead of ten-point nothing.
The old 'effective monthly interest rate' is still common among loan sharks, pawn shops, and other people who don't do everything in writing and who don't think their customers are very bright. So the introduction of APR did at least force all the mainstream lenders to standardise and come clean, so that you're in with half a chance of making an informed choice.
Why is APR still too complex for most people to calculate for themselves? Because your brain simply isn't wired to deal with what accountants call amortisation. If I tell you that you're going to pay 10 per cent APR on a £1,000 one-year loan, with 12 equal capital repayments and no up-front fees, you probably figure out that you'll end up paying £100 in interest. You're wrong.
Note
The reason you're wrong is that, although you certainly pay £8.50 in interest (£1,000 × 10/12) in the first month, your second month's interest payment's less than that. Remember, you've paid off one-twelfth of the capital as well as the interest, so now you only owe maybe £917 instead of £1,000. In the second month you're paying £7.63 in interest (£919 × 10/12), and in the third month £6.94 in interest (£833 × 10 / 12). Over the year as a whole, your average capital debt at any one time is exactly £500, or half of your original loan, because you're paying the loan off in equal instalments.
Even that model's too simple, though. Mostly people don't pay back loans and mortgages in equal capital instalments at all. Instead, the lender smooths out the taper to keep the monthly payments equal. In practice, that means that in the first months the lender only deducts a small capital repayment from the loan balance, so that a large part of the monthly payment is interest. By the end of the term, conversely, most of the payment is capital and only a tiny part is interest.
This amortisation effect makes working out exactly how much you're paying, for what, and at what point of the loan pretty well impossible for anyone without a degree in advanced maths. That's why investors depend so much on the benevolent rule of the Financial Services Authority to maintain order on their behalf and stop them from getting fleeced.
When it comes to investing your money in a savings account (or whatever), you want to know the Annual Equivalent Rate (AER). The AER is the real, absolutely genuine amount that you get from your savings account after a year, after making allowance for the effects of compounding. That's why it's also known as the effective interest rate.
But please note that the AER doesn't normally include the effects of any front-end charges, which may increase the bill. And AER gets into a right tangle if the loan is a multi-year arrangement that pays a different rate in the first and second years. That's quite common, by the way, in cash ISAs and savings builder accounts that try to lure you in with big first-year rates followed by not-so-big rates in the following years. Tread warily.
You may need the banks, but that doesn't mean that you have to put up with everything they decide to do to you.
As much as 85 per cent of a normal bank's revenues is estimated to come from the fines and fees it earns from people who don't manage their accounts well. I've talked about the very large fees of £35 or more that some banks charge on unauthorised overdrafts. But they're after your money in other ways too.
One is by holding your money for up to a week between the time you pay it in and the time it appears on your account. If you pay in a cheque today, the money may not be available for withdrawal until four or five working days have passed – and it probably won't be earning interest for you. This is nonsense, because banks can flash money across to each other in a couple of hours, and they have access to your cash a long time before you do. In effect, they're borrowing three or four days' worth of your interest.
How much interest are you getting on your current bank account? 75 per cent of people have no idea, and the rate's often just 0.1 per cent. You can make a difference by shopping around. At the time of writing Barclays were offering 2.5 per cent a year on a standard account, while Halifax were going as high as 5.12 per cent providing that you paid in at least £1,000 a month. But clearly, you'll need to do your own research if you want to know what's current right now.
Another favourite bank tactic, and one that annoys the regulators considerably, is the habit of persuading you to include Payment Protection Insurance (PPI) when you take out a bank loan. The general idea is that if you lose your job or fall ill, the PPI scheme carries on making the minimum payment instalments on your loans until you're fixed up again.
That may sound like a good idea, but it can add as much as 11 per cent to the annual interest rate on a typical loan. And all too often the PPI providers forget to mention that PPIs are mostly unsuitable for self-employed people, because you have to go through about a year's grief with HM Revenue and Customs before you get the paperwork that you need to be 'officially' out of work.
Worse, some banks have been caught slipping these PPI policies into their loan packages as part of the deal, so that their customers have no real choice about whether to take them up. A few online loan provider sites have sneaked them in by including an opt-out button for the PPI, which they hide so well that punters never even see it. All of this is illegal, and with luck it ought to stop soon.
Warning
PPIs are to the banks what extended warranties are to the electrical goods retailers in your high street – that is, they're three or four times too expensive in relation to what you get. The telephone salesperson trying to get you to sign up tells you that the PPI is only going to cost you 80p a month for every £100 you borrow. But when you realise that this is equivalent to £9.60 a year, or 9.6 per cent extra on top of your interest costs, it looks a little different.
Also consider routine service charges and premium accounts. Some high-street banks charge you a fee every time you cash a cheque or make a credit card transfer, and some credit cards make an annual charge, plus a withdrawal fee for cash. Some give you cash back, while others charge you a flat monthly fee for an account including a bundle of goodies that you probably don't need – such as travel insurance or Airmiles – but don't charge you for transactions.
Some let you open foreign currency accounts at attractive prices, while others struggle with a euro cheque. They give a lousy exchange rate and charge up to £30 for even looking at the cheque. Choose wisely.
Note
You do have a choice.