George Mavros, Chartered Financial Analyst and finance experts, discusses the power – and drawbacks – of cash when making investment decisions.
Many individuals turn to the financial markets to achieve their longer-term goals, be it the purchase of a house, sending kids to college or simply saving enough to retire with peace of mind. Done right, investing has the potential to provide higher returns than just cash, albeit at higher risk, helping individuals in achieving their goals with more ease. This, however, does not negate the role of cash in any portfolio (when referring to cash hereinafter, cash equivalent products are also included, such as fixed term deposits).
The possibility of an allocation to cash should not be ignored, as this asset class offers numerous benefits. As a starting point, cash acts as a ballast to riskier assets, such as equities, helping in reducing the overall portfolio volatility, while at the same time it can offer a steady, but low, stream of income. The stability of this income may be of considerable benefit, since it aids investors in their planning process, and reduces at least some of the uncertainty of how a portfolio will fund some of the goals set.
Another advantage of a positive allocation to cash is the asset class’ low sensitivity to interest rates. In other words, cash does not change in value due to a change in interest rates. As a result of this trait, cash can be combined with fixed income instruments to reduce the sensitivity to interest rates of the whole portfolio, hedging it against losses from rising rates.
Perhaps the most important benefit of holding cash is the ability to draw down these cash reserves first in cases of market downturns, to pay for expenses. This way, the investor is not forced to sell in-distress risky assets. Selling such assets to generate liquidity may permanently impair a portfolio, making it hard for an investor to meet the long-term goals set.
On the other hand, including cash in a portfolio has its limitations, too. Cash offers no appreciation potential, as the only source of returns is interest. On top of this, it usually generates lower returns than other asset classes. Consequentially, an investor will need to exert more effort to meet long-term goals, as a positive allocation to cash “eats up” from the allocation to other, higher yielding assets.
Compounding on the above, cash may not even protect the investor’s purchasing power. This arises if returns generated are not enough to cover inflation and over time, the investor will be able to buy less and less items. For example, average deposit rates in Cyprus stand at c.1%, while local inflation over the last twelve months (October 2017 to October 2018) has been 1.7%. Respectively in Germany, the 1-year Government bond yields -0.65% (as at 13 Nov 18) whereas October 2018 year-on-year inflation was 2.2%.
Tax considerations play an important role in defining returns earned from cash. Interest income is generally taxed at higher marginal rates, while tax payable cannot be deferred in the future, as is the case with capital gains tax.
Finally, one more important caveat to note is that the credit institutions at which cash are deposited to, are subject to default risk. Investors should not rest assured that cash investments are guaranteed, as the 2013 events in Cyprus have shown. The fact that the value of cash does not fluctuate in comparison to other risky assets, does not make them risk free – they are just exposed to a different risk. In general terms, the higher the implied risk of an institution, the higher the interest rate offered.
All in all, the amount of cash each investor should hold depends on a number of factors, such as the risk tolerance and liquidity needs. As a rule of thumb, the higher the risk tolerance and the lower the liquidity needs of an investor, the lower the allocation to cash.
Disclosure Past performance is no guarantee of future results. All investments involve risks, including possible loss of principal. The article is for informational purposes only and should not be interpreted as an offer to buy/sell any security or asset class. Any person who acts upon the information does so entirely at his own risk. Please consult an investment advisor before engaging in actions as a result of reading this article. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company mentioned in this article.