We've all heard the saying "Cash is king". Although this is true for many business applications, it's not always the case when it comes to investing. In fact, holding a significant amount of cash in your portfolio can be detrimental to your wealth over the long term. In this blog we look at why this is the case and give you some tools to test the theory out for yourself.
What's the issue?
Ultimately the purpose of an investment is to put money away today, in order to have more of it tomorrow. The two main enemies to achieving this are tax and inflation. We are all familiar with tax, and we see it's impact all the time. Inflation on the other hand is a bit more devious. Inflation is that slight increase in the price of things that means your dollar today isn't worth as much tomorrow.
The reason this is an issue when holding cash is that the returns (interest) generated are very low, and often not enough to ensure your dollar today is worth a dollar tomorrow. To illustrate this we look at some examples below.
Cash vs tax and inflation
As a starting point, lets look at a savings account with $1,000 in it. At the time of writing I may be able to get 2% interest (excluding temporary bonuses) on this account. So, after 1 year I would earn $20 in interest. If we assume that my tax rate is 37%, that means $7.40 goes to the tax man, and I'm left with $1,012.60 in my account. Even though it's not a massive return, on paper it looks like I've grown my wealth.
However, when we take into account inflation, things look a bit different. Inflation is currently around 2% as well. This means that $1 a year ago is only worth about $0.98 today. So the $1,012.60 showing on my bank statement only holds the value equivalent to $992.75 one year ago. Another way to interpret this is that a basket of goods that cost $992.75 when the account started, will cost $1,012.60 a year later. So the buying power of each dollar has decreased.
Therefore, even though on paper my account balance has increased, in the real world my wealth has gone down (i.e. the amount of things I can buy have decreased). And this is the main problem with holding cash investments for long periods. Also keep in mind that the longer cash is held for, and the higher inflation gets, the harsher the impact is.
Morningstar did some research using actual historical data and put their findings into the below figure.
The figure shows the returns for cash between 1997 and 2017 in green. The average interest rate over that time was 2.40% p.a. So, if $1,000 was invested at the start your bank statement would have shown a balance of $1,606.94 at the end of 2017. But after taking off tax, and adjusting for the reduction in real world value of each dollar, the account would only be worth $785.49.
The figure also shows the impact of tax an inflation on other types of investments. Although the impact is similar, because shares and bonds provide much better long term returns than cash, your $1,000 will be worth more if you invested in these assets over the same period. After accounting for inflation and tax the shares would be worth $1,914.28 and the bonds $1,172.76 (compared to the cash of $785.49).
This also illustrates that small increases in returns over long periods can have a big impact on the end result. To read more about this you can read "What's all this about 'time being money'?"
Does cash still have a place in a portfolio?
My intention with this blog is definitely not to reject cash, as it can play an important role in an investment portfolio when you need a short term defensive asset, which is easily accessible. Generally, if you will need to draw on a portfolio within 3 years it is a good idea to consider cash, because if you invest in something like shares and markets do fall there may not be enough time for your portfolio to recover. Whereas by holding cash, the portfolio value would not fall in the first place.
Cash can also be used by professional fund managers to properly align a portfolio with market conditions. For example, if a fund manager feels that there is a better chance of share markets going down than up, they may elect to hold cash instead. Then after share markets have fallen, and the fund manager has a more positive view they can invest the cash again, when shares prices are lower. In that way they minimise the chance of losses in the share market, but get the benefits when it bounces back.
So although there are significant drawbacks to holding cash in the medium to long term, it does play a role to meet short term cash flow, or portfolio positioning needs.
Useful tools
You can use this spreadsheet as a basic illustration of the impact that tax and inflation have on an investment. You can play around with the numbers to see what a big impact higher rates of inflation have on assets with low returns, such as cash, over the longer term.
You can also find the Morningstar chart used in the blog in this document. The document also has some other interesting charts put together by Morningstar.
Disclaimer: The information provided in this presentation is of a general nature only. It does not take your specific needs or circumstances into consideration. You should look at your own personal situation and requirements before making any financial decisions. Please seek personal financial advice prior to acting on this information.