Cash As A Viable Investment Especially In Real Terms

Us cash bills $20, $10, $1

It used to be said that “Cash is King”. In recent times the phrase “Cash is Trash,” has been more prevalent due to many investors fears of inflation. While it is true that physical cash has lost a great deal of purchasing power over a long period of time to inflation, cash invested in treasury bills has fared much better.

It is common knowledge that stocks and bonds offer greater returns than cash. Over long periods of time this has been especially true. It is also well understood that cash can outperform during short periods of time such as recessions. However, the general accepted best method to investing success is buy and hold. Therefore, moving in and out of stocks to cash has been shunned. I do not disagree with this advice. Yet, what if one included cash in their asset allocation?

Even though cash has not had relatively long periods of out performance in recent times this does not mean it cannot have strong extended periods and work well in a portfolio.

Recency bias seems to be in play in financial markets. In the last 30 years plus we have had falling interest rates. It is incredibly hard to predict which way rates will go, but there is no denying the importance they have. Namely as rates go down, risk asset values go up. This alone is not enough for use to make money in the markets, but can help explain the strong performance of stocks and bonds over this period in hindsight.

This is why I think many may be negating the benefits of cash at this time. Warren Buffet has been strongly criticized in recent years for his one hundred billion cash reserve in Berkshire.

Cash of course can be extremely valuable in a recession to buy under priced stocks, but this is not its only use. Cash will still receive some kind of return return if it is in treasuries or a bank account. At this time that value is essentially zero and would make most think there is no point in holding it. I think the issue is thinking about positions on a short time frame. Cash may not have a strong yield right now, but if rates do go higher later, and stocks and bonds fall, then you will lose less money being in cash at the present moment. I think this is the most obvious benefit. It also allows you to re balance back into stocks and bonds at lower prices. So you sacrifice some upside in strong markets, but it lowers the downside in bear markets. This can be a personal trade off.

Where cash can really shine

Many people are afraid of cash losing to inflation. However, it is possible that if rates move up alongside inflation that cash would actually maintain or be close to maintaining purchasing power. With extreme unexpected inflation long duration bonds would likely get hit hard, stocks would be hard to say, but cash should hold up well.

If deflation hits cash will also do fine. Long term bonds such as treasuries or AAA rated will likely do the very best. Yet cash will still do well. My main point is not that cash will outperform other assets. It generally will not, but on a consistent basis it should preserve its purchasing power relative for the amount of risk in holding it.

Japan as an example

Japan’s stock market peaked around 1990 at 40,000. Today it is around 20,000. With recency bias this is something I believe most US investors have not considered. In 2000, 2008, and most amazingly March 2020 we have seen big stock drops, with V shaped recoveries. This last crash we saw retail trades jump in after the sell off to ride the recovery up 40% and they have been rewarded. The question is will this continue to repeat indefinitely or could what happened in Japan happen here? Keep in mind we are not talking a small emerging country either, Japan is major developed nation. The good news for the long term investor who purchased the Nikki 225 in 1990 is they would have received a substantial amount of dividends over 30 years time to help make up a large portion of the loss. Yet holding through this downward move for an extended period of time would have been very tough.

Investigating further – Real Returns

On the surface the crash in Japan looks pretty dire. What is someone supposed to do now that stocks appear expensive in the US, bond yields are low, and cash is paying zero? Doesn’t this mean investing for retirement goals is impossible? Not so fast.

One thing that many people, myself included, do not consider is the real return. We all like to think nominally. We think of every dollar in our possession that we invest as a gain or loss. Since inflation has been relatively low in the US for the past 30 years this has had a more minor effect. I would imagine that bank rates and treasuries paid close to the inflation rates. So investors in cash may have a small loss in real terms, but otherwise were unaffected by inflation unlike those with cash under the mattress.

Example of Real Return

If inflation is 2% and a bank account pays 2.5% then the real return is 2.5% – 2% = .5%. Please note it is a little more complicated since you would pay tax on that 2.5% gain and that could erode the .5% real return entirely.

For bond and stock holders they have increased their purchasing power significantly. Bonds have done well as they have provided a higher yield than cash all the while enjoying bond price appreciation due to rate cuts.

If inflation on average was running at 2%, but a 60/40 stock bond portfolio returned 7% the investor would make a 5% real return. Again they would have to pay out taxes, but there would still be enough left to have a nice real gain beyond the 2% inflation rate.

Now let’s think back to Japan and examine where we are today. Japan has experienced deflation for a long time now. This is a unique situation where prices actually go down and money under the mattress becomes more valuable. That same money that earlier was eroding now actually make a positive real return. Nominally it is still zero but in real terms it can be significant.

This is very important to think about at the moment. If stocks prices seem high and bond yields are low how can anyone retire without getting a high enough investment return? The answer is they might not have to. Even if cash pays zero you could possibly make it through retirement under deflation.

Example: comparing inflation to deflation on living costs

If your standard monthly living costs are $2,000 a month under 2% inflation, then next year you would need $2,040. Over 12 months this is an increase of $480.

These same $2,000 under a 2% deflation would come in at $1,960. Or a savings of $480 over the course of the year.

This may not seem like a huge difference, but this is under mild inflation and deflation over the course of just 1 year. If mild deflation persisted for a decade at 2% this would eventually reduce the monthly living cost to $1,634. Now this is a $4,392 savings in costs over the course of the year.

Example: Depression deflation rate -10%

Under a serious depression such as 1929 the deflation rate hit 10%. If one was in cash even if it was yielding 0% you would have done real well. 0 – (-10) = +10% in real terms. So not only would you have avoided taking a large loss in in stocks, you actually would have made more “real” money.

Conclusion

So clearly we can see now how cash can grow in real terms even if nominally its yield is zero. It is the real return that matters. This post is not an attack on stocks, bonds, or any other investment. It is not a call to doomsday investing either. In no way am I suggesting to go 100% cash, although there is nothing wrong with it if you do. It is merely to make the case that cash is not as poor of an investment as many in the financial community make it out to be.

I believe the best opportunities one has is to stay diversified. If one has a portion to stocks, bonds, cash, and any other investment of their liking and does not try to time the market or make predictions for the future they will be well served.

Disclaimer: This article is for entertainment purposes only. Please seek a financial advisor before making any investment decisions. Do not make any decisions based on what you read from oncoronado.com

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