What's the best balance between savings and investments to control the risks, rewards and your own worst enemy: yourself!
When you have excess cash, I believe that a three-pronged approach is suitable for most people.
One of these prongs is buying your own home. Doing so at a fair price should pay off in the long run when your mortgage is history. But I don't need to sell that idea to the citizens of Britain and Northern Ireland! So today I'm focusing on the other two prongs: cash savings and equity investments.
Savings
For the ten years to 2008, our savings earned us on average a real return (i.e. after inflation) of 2.4% per year.* This means that after one average year our savings could buy 2.4% more stuff than the previous year, despite the rising cost of things we buy.
That was a great ten years for people with cash and its even better over the past 20, having been 3.5% pa after inflation.
Taking a longer-term view of 50 and 100 years, cash has produced a return of just 2% and 1% respectively. Even so, that's not bad. For a relatively safe thing to do with your spare cash - sticking it in savings accounts - even the average saver could have beaten inflation.
How savings compare with shares
For the ten years ending 2008, investing in the stock market will on average have given you a real (i.e. after inflation) loss: -1.5% per year. Compare this with our 2.4% pa for cash and you can see that it's been a dreadful period for shares!
Over the past twenty years, equities have done better, giving you 4.6% versus 3.5% from cash. Over longer periods, the difference widens considerably, and equities have consistently won.
Over any 18-year period during the 109 years to 2008, equities have beaten cash 99% of the time. What's more, over 23 years or more, equities have always provided an inflation-beating return. Despite the safety of cash, our savings can't claim that same record, having sometimes paid you not enough interest to keep up with rising prices.
Here's one more interesting point: the worst one-year return on shares since 1899 would have given you a real loss of about 60%, whereas the best performing year would have given you a gain of close to 100%. The subsequent behaviour of investors to these sorts of wild swings has shown that we are not psychologically suited to being investors. The majority of us end up panicking just like we didn't expect to, selling at or near the bottom, and not buying in again till shares have risen dizzily high, and we're caught up again in the excitement.
How much to save, how much to invest?
We have seen that shares usually beaten cash and often by a large margin - but they haven't always done so and we can't expect them to always do so, particularly over shorter periods.
We also know that, if you have a massive portion of your wealth on the line, you, like almost everyone else, will probably find it extremely difficult to cope with the loss when the market falls 30% or more - which it will do at various points in your investing life.
These points will help the average person with the average attitude to risk to better balance the risks and rewards. Here are some rules for how much you should invest and how much you should save (over and above your emergency savings, that is):
- If you're thinking of investing for just a few years, forget it. The market is too volatile.
- If you're investing for five to ten years, the risk of either poor returns, or a market crash that makes you panic and sell at the wrong time, still has a fair presence, so you should consider putting a smaller portion of your money into investments, perhaps 25%.
- If you're investing for ten to 20 years, you should consider putting maybe half your spare cash into investments. Keeping 50% in savings accounts could very well reduce your overall return, but it means that you can handle big falls psychologically, as you know that half your pot is safely in the bank, and your losses are therefore half as big.
- If you're investing for longer than 20 years and can't foresee a time when you'll ever need to remove your money from the stock market, you could go up to 75%. Keeping 25% in cash will still help reduce the very real chance of panic selling during the bad times.
The amounts I've suggested are arbitrary, but I think they'll give most people a good balance between risk, reward and your own worst investing enemy: yourself!
How to save
You can improve the odds of beating inflation with your savings by continually choosing top savings accounts and cash ISAs (tax-free savings accounts), and by looking for special opportunities.
If you want to make monthly contributions to savings, you can use either easy-access accounts or regular savings accounts. Before you decide where to put your savings, try out our Build up your savings goal to set you on the right track.
How to invest
Due to the stock market's tendency to rise most of the time, it can make sense to put in lump sums in one go. However, you can reduce the risk of investing by dripping in the same amount each month. That way you won't put all your money in when prices are high.
The easiest way to invest cheaply and get close to the stock market's returns is to open index trackers or ETFs. You can find out more by watching our I love tracker funds video, and you can see a selection of index trackers here. With these investments you can invest lump sums or make regular contributions. You should also join our Make money from the stock market join to help you come up with a successful strategy.
*All the figures in this article come from the latest version (2009) of the well-respected Barclays Equity Gilt Study. The figures for savings seem high to me and conflict with data from Moneyfacts, but it comes from a reliable annual report. I think the difference is because Moneyfacts quotes easy-access rates whilst the Barclays study probably quotes long-term fixes: something most people aren't prepared to risk on their money, as it takes away the benefits of keeping it flexible and in decades of higher inflation it could be disastrous. I don't see that this should change the guidance described in this article though, even if we were to use Moneyfact's data for cash.
More: The worst returns for savers since 1978 | Earn a better rate on your savings