The events of early 2020 are an unwelcome reminder of how important it is to have cash and liquid assets available in times of financial stress. Money in the bank is essential to meet ongoing spending and current liabilities on time. However, many households appear to hold far more than the standard six months of expenditure that might be needed in a stress scenario. In other words, they may hold too much cash.
This abundance of caution may simply be human nature. In troubled times, most people will try to avoid risk. But the perception that cash in the bank is safer than almost any other investment is actually not correct. In fact, it overlooks some important risks from holding too much wealth in the form of cash, especially long-term erosion of value.
As many investors are aware, bank deposit rates are increasingly headed below zero, and look set to stay there for several years. In some cases, private individuals and investment companies are even facing charges of up to 1% in negative interest rates for the privilege of taking their bank’s credit risk. That means cash can cost you money. And euro area short-term rates are now expected to stay well below zero until 2025, so this isn’t ending soon.
It gets worse. Cash without yield is vulnerable to further erosion from inflation. Even with Irish inflation averaging less than 1% per year in the past decade, cash has still lost about 8% in real purchasing power in that time (and nearly 30% over 20 years). As central banks and governments undertake unprecedented stimulus to counteract the economic damage from coronavirus, the risks of a more inflationary cycle ahead are rising.
The upshot is that cash has been a significantly underperforming asset. In the 10 years to end-March 2020, the return on euro cash has been approximately zero, while a well-diversified equity portfolio has more than doubled. Equities returned an annual average 7.35%, while bonds returned 3.05% on the same basis.* An equally balanced portfolio of global bonds and equities has meanwhile returned approximately 5.5%, with much less volatility than equities alone.
Considering the balance of available risks and rewards, most people should maintain only modest cash holdings. The real question is what to do instead, without taking on inappropriate levels of risk with capital that needs to stay reasonably liquid.
At Goodbody we take a graduated, step by step approach that starts with an assessment of current cash holdings in terms of yield and considers a range of options for different risk profiles.
- Spread your cash. No matter how confident you are in the stability of the financial system, it is sensible to diversify large cash holdings among the highest rated institutions to take the full benefit from deposit guarantee protections.
- Safety first. Switching some portion of excess cash balances to the highest-grade government bonds should appeal, whether in custody holdings or simple fund form.
- Avoid negative rates. For larger amounts, another option is positive-yielding, short-maturity fixed income portfolio. This may appeal as an alternative to at least some portion of cash deposits, over and above what may be needed for immediate precautionary purposes. Such a portfolio can be constructed of primarily high-grade, short-dated corporate securities – with a small share of other diversified credit risks to increase yield further as desired. A conservative blend of credit exposure can generate a yield well in excess of 1%, with low risk in a portfolio context.
- Increase risk-adjusted returns. The higher-risk alternative for further excess cash balances, is a blended portfolio of equities and bonds. While equities alone remain a higher risk part of the capital structure, prone to occasional but significant drawdowns, a well-balanced portfolio has a high probability of at least preserving value and potentially adding significant growth over a five-year time horizon.
It is a good idea for investors to review why they hold cash, how much is needed, and what risks you are exposed to – and then to consider what options exist to diversify, avoid capital erosion, preserve purchasing power and potentially pursue capital growth. Doing nothing is not a risk-free course of action.