3 underappreciated benefits of cash
Cash gets a bad rap - this episode of Investing Compass runs through how investors can use it to their advantage.
In this episode, Mark and Shani challenge the common investing belief that cash is always a poor investment because of its low long-term returns.
They argue the case for cash and outline the several important benefits that are often ignored when investors focus only on measurable returns.
They run through how the opportunity cost of cash declines as you age, how it provides peace of mind and how it provides investors with dry powder.
Read the full article here.
A few more resources on the role of cash in investors’ portfolios:
Future Focus: The tax-free returns Aussies are taking advantage of. There are smart ways to take advantage of your offset account, but balance is the key.
New data shows that Aussies have sizeable offset accounts, on average, 11% of the loan limit. Is this the right amount? Shani runs through the framework she uses to decide what should and shouldn’t sit inside of her offset account.
What is the right amount of cash to hold in your portfolio? How should you decide on the appropriate level of cash to hold? We believe there are several points an investor should consider.
Cash is a very useful tool for investors within all portfolios, with utility that provides liquidity and capital protection. However, it has a long history of underperforming almost every other asset class. So, how does one decide on the appropriate level of cash to hold? When sizing, there are several points an investor should consider in the portfolio construction process.
With term deposit rates falling, bonds holding up but with risks attached, and stocks yielding comparatively paltry sums, finding decent income is becoming harder. James Gruber discusses how cash ETFs and bank savings stack up in an environment where many assets are under pressure for yield.
Is it worth venturing beyond cash and term deposits for steady income? This looks at the pros and cons of assets - including stocks, bonds, and hybrids - in providing yield and how they stack up against cash.
How much cash should you hold in retirement? A diversified portfolio with various time frames can help you meet your income needs during retirement.
You can find the transcript below:
Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances, or needs.
Mark LaMonica: So we’re going to do an episode on cash today, Shani.
Jayamanne: And it’s not our first episode on cash.
LaMonica: Yes. So embarrassingly, we named our previous episode, Cash Rules Everything Around Me. And that was an allusion to a song by the Wu-Tang Clan.
Jayamanne: I mean, I think you named that episode, Mark.
LaMonica: Well, yes, I believe you were on leave. And so I took a little poetic license when I named that. But it was a phase where we were trying to be creative in how we named episodes. Let’s move on to today’s episode. Before we get into it, we do need to frame this discussion a little bit. We’re going to talk about the benefits of cash. But we do want to be clear that we both believe that the only way to build wealth over the long term and achieve financial freedom is to invest.
Jayamanne: And the problem with cash is that over the long run, you earn a return that barely exceeds inflation. So we did a previous episode on this and wrote about it in our book as well. But it was taking real or inflation adjusted returns over the last 30 years and looking at how long it would take to double the real purchasing power of a portfolio invested in that asset class.
LaMonica: And this, of course, is the rule of 72. That means if you divide 72 by the annual return, it tells you how long it takes to double your investment.
Jayamanne: And in inflation adjusted returns, it takes 48 years to double your portfolio in cash. If the returns from the last 30 years repeat, that’s longer than most Australians work. So for US shares, the double happens in 8.57 years. Australian shares 11.25 years.
LaMonica: So this is just some context as you listen to this episode that is really important to invest.
Jayamanne: And the origin of the episode is an article that you wrote, Mark, and you came up with three underappreciated benefits of cash. So what’s the first one?
LaMonica: Well, for the first one, I used my one advantage over you, Shani, and that is my advanced age. So my first advantage is the value of cash increases as you age. And my attitude used to be very anti-cash. So when I was younger, I kept my emergency fund as small as possible. And I tried to get every dollar possible into the share market. And I’m really glad that I did that because we both know the most valuable resource for any investor, Shani is…
Jayamanne: Time.
LaMonica: Exactly.
Jayamanne: And when you are young, you have the most time possible. And that means the opportunity cost is higher for not investing and holding cash.
LaMonica: That’s right, Shani, but as you age, that opportunity cost goes down. So we can demonstrate that doing some projections using returns from the last 30 years. Over a 40-year period, a $10,000 investment in Aussie shares would grow to $133,837 in spending power. Over 10 years, the spending power of an investment in Aussie shares would be $19,126, while cash would grow to $11,605.
Jayamanne: And over 40 years, your purchasing power would be 637% higher by investing in shares. And over 10 years, it would be 64% higher. This is the power of compounding, and it really illustrates the difference in opportunity cost. So how should an investor think about this?
LaMonica: Well, I think very simply, it means that with a lower opportunity cost, it means there’s less of a hurdle for cash’s benefits to overcome.
Jayamanne: All right, so let’s move on to another benefit.
LaMonica: Okay, peace of mind, Shani. So it’s very difficult to obtain peace of mind. This is obvious from the definition, which is a state in which your brain is calm, at ease, or untroubled by worry, and everybody worries about something.
Jayamanne: I worry about a lot of things.
LaMonica: That is true. We all worry about a lot of things, just maybe not quite as much as you, Shani. But I can talk a little bit about my own experience, which I think is fairly typical. As my net worth and salary increased, it has not alleviated me of financial worries. Obviously, to compare my financial worries with somebody struggling to put food on the table really shows a lack of empathy. But I can still say that I can be worried about things while admitting that my life is actually pretty good.
Jayamanne: And I battle with this as well, which we’ve talked about on the podcast before. I have to actively fight the urge to commit every dollar I have to paying off debt because that makes me anxious. And even though I know it is better to invest the money, and that’s what I do, it can be hard.
LaMonica: And I think this is where you need to gauge where you are in life. So I also know that you are very good about having a fully funded emergency fund, which I’m sure provides some peace of mind about anything that actually comes up.
Jayamanne: I do, and that’s what gives me confidence to invest.
LaMonica: Exactly. And I think we need to remember that peace of mind is not a binary state. So you don’t go to bed, not having peace of mind and then wake up in the morning with it. So it is a scale and cash provides peace of mind in a way that other assets don’t. So now like any old man, I’m going to tell a story. And I do consider myself a confident investor, hopefully competent as well. But in the back of my mind, there’s this little voice whispering that the 1929 crash and the Great Depression could be right around the corner. And I think with all the bubble talk that we’ve had recently, a lot of investors may be hearing this voice as well. So I think the key here is balance. When that voice gets too loud, people end up with their entire net worth in a shoebox under their bed. When it is completely ignored, people borrow money to go buy one day options. And the advice I would give everyone is to spend some time thinking about the right balance for you between peace of mind and higher returns. So revisit that decision as you age, because it’s likely going to change during different stages of your life.
Jayamanne: And we’ve got one more use of cash, but this is one we’re varying disagreement. So I thought I’d go through my approach first. Other than my emergency fund, I don’t hold any cash. And my portfolio focuses on strategic asset allocation. So that means ensuring that the asset classes and investments that I have in my portfolio are aligned with my goals. So rain, hail or shine, I’ll make additional investments that set intervals into these allocations. And tactical allocations are made based on market conditions. And they focus on finding the best opportunities possible and usually involves having a cash allocation to take advantage of these opportunities.
LaMonica: And even though many investors don’t use this language, a lot of people use these tactical allocations. So they go to more cash when the market seems risky, and then they put more money into the market when things seem attractive.
Jayamanne: And the problem with this is that it’s very difficult to do. Investors tend to think that the market is risky when it’s going down and valuations are attractive and think it’s a great opportunity when it has gone up.
LaMonica: And this is called recency bias. So it means we expect what has happened recently to continue, which makes market timing even harder.
Jayamanne: And this just isn’t a game that I want to play. And this is because of the data. So over the last 30 years, if you miss the S&P 500’s 10 best days, your return would be cut in half. If you miss the best 30 days over 30 years, your return would be 83% lower.
LaMonica: Now, I do want to start by saying I agree with everything that you said, everything that Shani said. And we’ll also admit that my perspective is shaped by my personal situation, which of course is shaped by my age. So when you are young, each new contribution is relatively large compared to what is generally a small portfolio. As your portfolio grows, contributions are proportionately smaller. So as you age, your savings matter less and your returns matter more. So I am comfortable holding more cash at my age because I’m on track to achieve my goals. And the opportunity cost as we’ve been talking about is lower. So extra dry powder can come in handy to take advantage of opportunities and taking advantage of opportunities won’t resemble some fantasy scenario where you catch the market bottom. It will be supplementing the savings from my paycheck by drawing down on cash.
So I won’t go all in at a certain point. I won’t catch the bottom unless it’s just dumb luck. I’ll simply try and take advantage of any attractive opportunities that may present themselves. So one note of caution, increasing your cash savings as you age is very different than selling assets and raising cash based on market conditions. That’s market timing and investors are notoriously bad at it.
Jayamanne: So the overall lesson here is that your goals matter. The investment approach you take should be based on what you’re trying to achieve and your personal circumstances. So we want there to be a right answer to every personal finance and investing problem, but there is no right answer because that presupposes you know the future. And it seems that we’re all the same, which isn’t true. So spend some time thinking about what you’re trying to accomplish and the advantages and disadvantages of taking different approaches.
LaMonica: All right, great. We will leave that there. Thank you very much for listening to our more appropriately named episode on cash.
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