A nickel ain’t worth a dime anymore.
~ Yogi Berra
Update: This article was chosen for the Best of Money Carnival, #Sexty-Two at Budgets Are Sexy. Thanks! It was also included in the first ever Carnival of Wealth posted at Personal Dividends. Thank you!
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:
- Your view on inflation vs. deflation.
- Your views on economic growth.
- 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.
(Disclosure: I hold more than 90% of my money in cash at the time of writing.)
What’s your view on cash? Trash or king?