How to Invest Your Money » Investing

Cash: Is It Trash or King?

A nickel ain’t worth a dime anymore.

~ Yogi Berra

When we looked at the current pros and cons of investing in commodities and real estate, it became quite apparent that there are some pretty good arguments on both sides of the debate. We often hear contradictory truisms. Cash is trash. Cash is king. Which is it?

The correct answer is likely “it depends”. There are times when it’s prudent to hold more cash, and there are times when it makes sense to move more money into riskier assets like the ones we’ve been discussing this week. Today, we’ll take a look at the case for each and hopefully help you decide where you want to be on the cash spectrum.

As in most debates, there’s a little truth in each extreme, but the greatest knowledge lies in the middle. Further, the best cash allocation for me may not be the best for you. A lot will depend on your unique financial situation and your views on the macroeconomic climate. With those disclaimers out of the way, let’s get right into the Trash vs. King debate.

Cash Is Trash

Here are the most common arguments for holding less cash, as opposed to other assets like stocks, bonds, real estate, or commodities:

  • By far the most frequent (and valid) argument is that returns on cash may not outperform inflation, leading to negative real returns.
  • You can achieve a much higher return on your money in just about any other asset class as long as the economy is performing reasonably well.
  • Cash yields (especially in money market funds) are particularly pathetic right now, running anywhere from a fraction of a percent to 2% for some high interest savings accounts.
  • If inflation spikes, the purchasing power of your cash will fall, so you will be able to buy less stuff for the same amount of cash.

Cash Is King

Here are the most common arguments for holding more cash:

  • Cash is the safest investment, and often comes with a CDIC (or FDIC) guarantee. (Money market mutual funds are not guaranteed.)
  • If deflation is the order of the day, cash is the place to be.
  • Economic slowdowns and volatility can lead investors to reduce risk by selling other asset classes, thereby driving their prices down significantly. Cash doesn’t usually experience these big swings.
  • If you don’t hold a decent amount of cash, you won’t be ready to buy when other asset classes get hit.

Royalty or Rubbish?

In the end, how much cash you choose to hold will depend on a few main decisions:

  1. Your view on inflation vs. deflation.
  2. Your views on economic growth.
  3. Your risk tolerance.

There have been a number of good arguments put forth on the first two issues, with some arguing that the stock market is about to rally again, and others firmly staking their tents in the Japanese deflation camp. Your position on these pivotal issues will likely determine the percentage of cash that you will hold. But perhaps more important is your position on number 3.

Which is more important to you: preservation of capital or higher return on your investments? If we’re all honest with ourselves, we would probably unanimously agree that we really want both. Unfortunately, that’s not how it works. By determining your cash allocation, you’re really putting a number on each. Obviously, the older you are, the higher your cash allocation should be.

Regular readers already know that I favour capital preservation right now. I tend to be in the deflation now, inflation later crowd. I see the problems presented by high sovereign and consumer debt levels as a threat to the global economy and financial stability. I think it will take some time before we can work off the excess capacity and leverage in the financial system. While I definitely see the potential for reflex rallies in the markets, I still believe that capital preservation should be the order of the day until a) we understand the length and depth of the current deflationary turn and b) the global deleveraging process is closer to being completed.

The Ultimate Diversifier

I recently wrote that these markets currently offer no respite in diversification because of the increasing correlations within and between asset classes. That’s another reason I favour cash at the moment. It’s the ultimate diversifier. (I know that’s not a word, but if the President of the United States can say “decider”, I can coin the term “diversifier”.) The one certain way to reduce risk in your investments is to simply increase your cash allocation. Stocks, bonds, commodities and real estate can suffer large capital losses relatively quickly when risk levels are elevated, as I believe they are now.

I’ve heard the argument before that holding high levels of cash is actually riskier than holding a diversified portfolio of high quality stocks and bonds, but I’ve never been able to make myself believe it. Even if inflation rises, reducing the purchasing power of my cash, interest rates will rise to compensate for that. The interest rate-inflation differential would have to be pretty huge to compare with the 20% plus drop in stocks or other asset classes that is possible.

Now I’m not advocating a 100% cash position for everyone, although my personal accounts are close to that level at the moment. I’m just saying that there are some pretty substantial risks out there right now, so shuffling your mix of equities and bonds probably won’t offer the same risk reduction bang you can get by shifting more bucks into cash.

What’s your view on cash? Trash or king?

Comments

  1. Roshawn @ Watson Inc

    Very thoughtful analysis of the merits of keeping cash in your portfolio. One’s risk tolerance does seem to vary based on age and level of wealth… Good stuff 2cents!

    • 2 Cents

      Yeah. There’s definitely no “one size fits all” strategy here, but I think we sometimes forget that reducing risk can be as easy as raising cash. Thanks Shawn! 🙂

  2. Ethan

    1. “Cash is the safest investment…FDIC…[etc.]” In the ultimate sense of the the word “safe” – that is, risk of total loss – Treasuries have the same level of backing. Of course they can temporarily lose value between purchase and maturity, but you are paid for that risk. And you have the option of full inflation protection, which you can never get with cash or any cash equivalent.

    2. “If deflation is the order of the day, cash is the place to be.” Treasuries aren’t significantly different. Obviously they can fluctuate in value, but that is true compared to cash in all environments – it’s not something that comes about because of deflation anymore than because of inflation. Owning high-quality, fixed-rate debt during deflationary periods is great. The slowdown doesn’t hurt it because it’s high-quality, and the fixed rate is effectively increased by the deflation.

    3. “Economic slowdowns and volatility can lead investors to reduce risk by selling other asset classes, thereby driving their prices down significantly. Cash doesn’t usually experience these big swings.” Ditto for high-quality, short-term debt. In fact it will often get driven up under these circumstances. Check out the Vanguard Treasury funds during the recent slowdown and volatility.

    4. “If you don’t hold a decent amount of cash, you won’t be ready to buy when other asset classes get hit.” Unless you were holding high-quality debt, which wouldn’t get hit with those other asset classes, as above.

    At a macro level it is obvious why this would be the case. If you are holding short-term, nominal Treasuries you are earning just a bit of return but your principle is going to behave nearly identically to cash. You’ll still be liquid because it’s not going to vary much from the equivalent cash position. If you are holding long-term, nominal Treasuries then you win when reality holds more deflation than they were priced for, and lose if it holds more inflation. If you are holding TIPS then your *real* returns will mimic the stability of the short-term nominals (low but steady real return), thought you may experience significant value fluctuations between purchase and maturity.

    Any of those choices might make more sense based on the investor’s situation, but short-term, nominal Treasuries are going to have a small return in virtually every environment, including deflation. Unless you can match that return in CD’s, the bonds are preferable.

    • 2 Cents

      You make some good points regarding Treasuries, but I still prefer cash for its simplicity and liquidity. You can get in or out of cash at any time, whereas you may need to hold short term debt instruments to maturity to avoid capital losses. Many CDs (GICs in Canada) or even high interest savings accounts pay as much or more than short term debt instruments without the fees and hassles of buying individual bonds.

      TIPS do provide great inflation protection, but the yield on some of them actually went negative yesterday due to the current deflationary fears. Again, I would rather have cash.

      I do think that there is a place for bonds in every portfolio, but for safety, simplicity and liquidity, you just can’t beat cash. Thanks for stopping by!

  3. Financial Samurai

    Cash is the mofu King baby!

    I earn about $25,000 a year risk free in interest income just from the cash sitting in various CDs in various banks.

    There is NOTHING I would do to take out my cash and invest it in something else. That’s what my company stock, 401K are for, and there’s enough of it invested after you’ve been contributing for a number years.

    10 more years, and I hope to accumulate enough cash to return $100,000 a year risk free. I’m not greedy and will hapily live off that.

    Best,

    Sam

    • 2 Cents

      It sounds like you have a solid plan. I’d be pretty happy with $100K in income too. Congratulations!

  4. Adam

    A really interesting article.

    I see cash as ‘opportunity money’ rather than safety money so I’m surprised about your huge current allocation -I guess I’m not convinced about deflation.

    That said, the great thing about this article is that it promotes thinking about allocation, rather than just maintaining the status quo and its great being in a position to even make a decision about what to do with cash- lots of people have no cash.

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