Why Cash May Not Always Be King!
Cash as an asset is very comfortable for many people to own. It is an asset you can actually touch, feel and hold. Prudent financial and investment planning suggest that you should hold some cash, especially for emergency purposes. Often, 3 to 6 months and sometimes more depending on your personal situation is a good rule of thumb. There are some situations where holding more cash might be prudent. One example that comes to mind are people that have specific known medical conditions that require cash to cover the expenses of healthcare that insurance does not cover. Having cash often helps provide a sense of safety and a feeling of being able to sleep better at night. That is completely understandable!
I have found that the job of a professional advisor is to listen to a client’s needs and craft a plan that has the greatest chance of achieving those needs. I tell my clients that my job is not to tell you what makes you feel good but to advise you on what needs to be done to achieve those goals. That said let’s take a look at Cash as an asset and how potentially the good feeling of having lots of cash, “Cash Is King” may not be the best and potentially could be increasing your risk.
In order to understand that cash may not be king we must understand the effects of inflation on our buying power, and current and historical interest rates on cash. We will use CPI (Consumer Price Index) as the proxy for inflation and the 30 day treasury bill rate for the interest rate on cash, as is customary.
First: inflation as measured by CPI can be defined as a sustained increase in the general price we pay for goods and services over a period of time. We all know that the price of a loaf of bread has gone up since we first started eating it in our childhood. So we understand that things get more expensive over time. If we put money in our mattress when we were 3 years old to buy 10 loafs of bread at the price we would have paid for it then and took it out several years later we would likely not be able to buy as much bread. That can be what holding cash can do if no interest or rate of return is achieved on it.
Second: cash as an asset class is typically not stored in mattresses. More commonly it is stored in bank accounts and brokerage accounts. Rates of interest on cash have varied widely over the past 20 years and for quite some time have averaged 0% in most cases.
Let’s now assume that for a period of 5 years inflation averaged 2.5% and cash averaged 0% interest. Our simplistic real rate of return on that cash is not 0% it is negative 2.5%. Hence we have been losing money during that time and not even potentially realizing it because, well, we still have the same amount of dollars on hand so “I did not lose any of them.” That is factually correct that you have not lost any of the dollars you can count but you have lost on the amount of goods you can turn those dollars into.
Starting off in a position where you are in a negative return scenario right out of the box is a hard perspective for investors to grasp but that is exactly what has been happening for the majority of the last 5 years. Looks to me like holding cash is risky and potentially more risky than many know. This is at the core of why Financial Professionals after understanding a person’s current situation, future goals, feelings and family dynamics, as well as one’s understanding of risk and tolerance for it may need to recommend less cash as a percentage of portfolio holdings than someone may find comforting. We as professionals need to strike the best balance we possibly can in order to achieve those goals. Even if the goals are not exactly achievable, it is our duty to provide a plan that can make the money invested last as long as possible, to achieve as much of the goal as possible. Ultimately, however, investors comfort levels are important and should they decide that holding cash still feels best in light of what we just reviewed then "Maybe Cash Is King" for those investors.
For those of you who are technically and visually minded the following chart will illustrate this issue. It is a 20 year chart dated 03/18/1995 to 03/18/2015:
This chart illustrates the relationship between the inflation rate (measured by CPI) in the United States and interest rates on cash (measured by 3 month treasury rate). We have named the blue line US Inflation rate which is the monthly inflation rate measured by CPI. The Orange line is the cumulative growth of the consumer price index which illustrates the cumulative effect of inflation on goods and services. The Red line is the average monthly rates of return on a 90 day treasury bill, our proxy for interest rates on cash.
What we see is that although inflation rates and 90 day treasury bill rates diverge, cumulative inflation continues to increase, showing that our goods and services get more expensive over time and interest rates on cash do not always help us combat this phenomena. Furthermore, we can be in periods of time, which are multiple years in length, where cash interest rates are lagging behind the rate of inflation. This greatly reduces the effectiveness of our cash as a purchaser of goods and services. Also important to understand is that these negative divergences require us to spend more money on an item in times of low interest rates or negative real interest rates on cash, further hampering the ability for our money to grow when cash rates of return are higher. Why is this, it is because we have to spend more of the cash during these times and we have less of it saved for when rates are above inflation helping us actually grow our money.
Ultimately we must all be comfortable with our investment portfolios and cash is a major component of the mix of assets we own. Hopefully next time you here the phrase “Cash is King” you remember that maybe it truly isn’t as safe as you once thought.
Disclaimer: The Charts provided in this article was produced by Ycharts a third party provider of analytical data and charts. We believe that the information used to create this chart is accurate to the best of our knowledge however we cannot guarantee the accuracy of its content.