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Wednesday, June 12, 2024

The Deceptive Allure of Cash


This article was originally produced for Livewire Markets

 

In Homer’s epic poem The Odyssey, beautiful Sirens attempt to lure sailors off course by hypnotising them with their song and causing them to crash into rocks and land.

Is the allure of cash currently having a similar effect on investors? 

With some banks now offering north of 5% on savings, cash and cash products have re-entered the thoughts of investors, after being absent for so many years of ultra-low interest rates. That’s good news for investors. It’s also good news for markets. The “hunt for yield” when interest rates were zero caused harmful distortions in the market for capital. 

Yet higher rates on cash brings risks of its own. Five percent might be better than zero percent, but cash is still a horrible long-term investment. And that’s a lesson many investors are learning the hard way.

The Illusion of Current Cash Returns

In a financial world where there has been over a decade of low interest rates, it’s easy to get excited about the opportunity to earn what appears to be a decent return on cash. High-yield savings accounts, certificates of deposit (CDs), and money market accounts are currently offering annual percentage returns in the range of 5-6%, and in some cases even higher. These returns appear competitive when compared with the last decade of low-rates, leading some investors to favour cash as a safe and accessible means to grow their wealth or as a less risky alternative to equities.

Comparing Cash Returns Over Time

While the immediate returns on cash seem appealing, a closer examination reveals a different story. Cash rates are higher at the moment because inflation has been higher – this means the real rate of return on a cash investment, after accounting for inflation, is close to zero. As you can see in the table below, that’s always been the case with cash. At best you will retain your purchasing power. If inflation falls, interest rates will fall too, and your 5% return will become 3% or 4% before you know it.

Stocks offer much better real rates of return than cash and cash products over long periods. Stocks have generated an average real rate of return ranging from 6% to 7% annually over the past 100 years. You have been able to earn those returns plus inflation by owning these real assets.

Big differences over the long term

Four to six percent might not sound like a massive difference. But when the power of compounding works its magic, the differences become stark over time.

Let’s imagine two hypothetical investors: one who places $10,000 in a high-yield savings account at 5% annual return, and another who invests the same amount in stocks in an Exchange Traded Fund (ETF) with a 10% annual return (assume inflation of 5% plus 5% real return). After one year, the cash investor earns $500 in interest, while the ETF investor’s investment grows to $11,000. Not a huge difference over a year, so you might as well favour the safe haven of cash?

Fast forward ten years though, and the cash investor’s $10,000 has grown to $16,386. That’s not buying any more than it was. The ETF investor’s investment has ballooned to $25,937 – a much greater difference to the cash return – showcasing the true advantage of higher returns over time, and in turn providing a real rate of return after accounting for inflation.

The Compounding Conundrum

Now, let’s take this comparison to a more extended time frame, say 25 years. The cash investor’s $10,000 has grown to $33,864, a seemingly impressive feat. However, the ETF investor’s initial $10,000 has now grown into a huge $108,347. The gap between the two investors’ returns is now strikingly wide. At 30 years, the cash investor would have $43,219 versus the ETF investors $174,494.

This phenomenon is the essence of compounding. While cash investments may provide an appealing yield in the short term, their low real rates of return limit the potential for long-term growth.

The Cost of Safety

Many investors understand the maths above. Their strategy is not to be invested in cash for the long term, but to park their money in cash until the outlook for equities improves. That’s perfectly understandable. When bank interest rates first hit 5% in mid 2023, equity markets were in a tizz. With recession looming and inflation running riot, who wouldn’t be attracted to the safety of a government guaranteed bank account?

Well, me for one. The “wait till the coast is clear” approach is the most pervasive, wealth destroying, unshakeable investor mindset I see. And there is no better example than the past 12 months.

Feeling a bit better about the world? Inflation seems to be subsiding. The economy seems to be holding up ok. The RBA is talking about the potential for rate cuts.

Well, I’ve got bad news for you. Stock prices have since surged, making it 20% more expensive to buy back into the market than when you were feeling worried. In the US and Australia, equity markets are at all-time highs.

Combine this with the prospect of lower rates on cash and the investor is hit with a double whammy that could potentially cost years worth of returns.

The Allure of Cash may be Enticing Today, but..

Cash, of course, plays an increasingly important role in most investors’ portfolios. Their priority should be an asset allocation plan (this may change as an investor reaches different stages in their life, and should include a growing allocation to liquid assets like cash over time).

Once you have a plan, though, it needs to be stuck with, through thick and thin. Odysseus (from our famous poem) went to the lengths of strapping himself to the mast of his ship and getting the sailors to plug their ears with beeswax so they wouldn’t be distracted by the song of the sirens. By doing this, Odysseus managed to sail unscathed through the notorious straits between Sicily and Italy. Whilst we don’t suggest strapping yourself to a mast any time soon, it’s worth remembering this story if you ever consider wavering from your investment strategy during future times of market panic. The allure of cash in times of distress is nothing more than that, an allure that should be avoided.


References: Sirens in the Odyssey

Portfolio Allocation

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