OK, so the title may sound ridiculous – could there be a more first world problem?
But having too much cash sat idle in a portfolio is actually a common issue. I’ve been doing some more financial coaching this week and this comes up a lot.
Many smart, hardworking people are good at earning and saving but have a blind spot when it comes to investing. They accumulate cash savings but then get stuck, often due to lack of confidence or fear. People get paralysed by indecision and the endless choices available.
Don’t get me wrong, its important to have a cash reserve. This could be a stash of say 3 – 6 months spending as an emergency fund for unforeseen expenses (e.g. house or car repairs). You should also allocate cash for near term liabilities such as a tax bill due within a year.
If you are retired, its also helpful to have some cash (or government bonds that can be turned into cash easily during a crash) so that you never need be a forced seller of equities to fund living costs. If you have enough gilts (or treasuries) to cover say 3 – 5 years of spending, that’s enough to cover most bear markets.
But people who are still earning and working full time should generally be putting idle cash balances to work, preferably into productive real assets (either shares or property).
Buy to let landlording provides a successful route to wealth-building for many. In the UK, 50 years of population growth combined with planning restrictions have given people the quaint notion that you can’t go wrong with property. Unfortunately you can definitely go wrong with property (and mortgages) as many people found in 1981 when UK interest rates hit 17% and 1992 when they briefly hit 15%.
Real estate has a couple of key psychological advantages over equities. People love the fact that they can see and kick their property: It must be real, my foot hurts! They also like that there is no market price quoted on a screen. That way, they can ignore price fluctuations and pretend they don’t exist.
But as Ben Graham explains in The Intelligent Investor, the fact that equities have easy marketability should only be an advantage for the rational investor and never a drawback. A market price for a stock provides an option that can either be ignored or used.
People fear the feelings of loss and regret they will experience if they buy equities and the market then falls. As a result, they swap the chance of a short term loss with likely long term profits (equities) for the certainty of a long term loss (cash).
As a result of inflation and tax, the purchasing power of cash is reduced every year. If you are lucky it will happen slowly – the real value of your cash will shrink over time like an ice sculpture at a party. 2% annual inflation halves the real value of £100 in approximately 36 years. 5% annual inflation halves the real value of £100 in approximately 14 years.
Here’s the problem. The return on cash currently provides insufficient compensation for the risks you are running. Let me put that a simpler, cruder way. If you sit in cash, the government is gonna screw you. Governments across the West are holding down interest rates and monetising their debt via quantitative easing to fend off deflation. They are deliberately trying to engineer inflation into the system to erode the real value of their debt burdens.
Do not blame governments for this. They are only doing what their masters (us) have instructed them to do. We The People elected representatives that spent more on schools, hospitals, guns and paperclips than they raised from taxes. The government then borrowed to make up the difference. Unfortunately things got a bit out of hand on this front, so the Government is now going to have to inflate away the real value of the debt over a period of years.
This is nothing new. In 1945 Britain had accumulated huge debts to fight the second world war. Government debt to nominal GDP peaked at 240%. Over the next 35 or so years, governments ran policy to engineer inflation. In 1974, retail price inflation peaked at 26%. Unpleasant as this was, it worked. Government debt to nominal GDP fell below 30% in the early 2000s.
People think that all cash savings are safe. But are they really? Sure, the face value of the principal may not fluctuate. But try telling a depositor in a Cyprus or Zimbabwean bank that cash on deposit is safe. I suggest you then stand well back.
If you think cash is safe, your imagination may not be active enough. Imagine annual inflation back over 25% and interest rates held down close to zero via quantitative easing. How safe does your cash look then? Even if inflation stays in its cage for the foreseeable future, your money is not growing – you are not allowing compounding to work its magic over the 20 or so year period that it takes to get to financial independence.
Investing is full of paradoxes. One of the greatest paradoxes is that safety is often an illusion. The flipside of this is that productive risk assets may be safer than they appear.
The beauty of equities is not that they are “safe”. Rather it is that their dangers are obvious to everyone. In the last 15 years, we have had 2 bear markets where equities roughly halved from peak to trough. The good news is that everyone knows this and people fear this volatility…even long term investors who are net buyers of equities and who should hope for lower equity prices rather than fear them.
Back to the risks of cash. Cash is a form of fixed income investment. Fixed income can provide a useful form of diversification from equities – think of it like a buffer that provides stability in a market crash.
We all need some cash somewhere safe as an emergency fund. So yes, I do have some cash and other fixed income in my portfolio.
But there is a problem with fixed income investments, especially higher yielding income investments such as corporate bonds or building society PIBs. They combine an obvious but limited upside with a non-obvious risk of total wipe out. These are the characteristics of a turkey distribution.
To illustrate, imagine you are born a turkey*.
You live on a farm, surrounded by your friends and relatives. In the evening, you sleep in a comfortable barn where the temperature never falls to freezing and where you are protected from foxes, wolves and other predators that plagued your wild ancestors.
Every day, the farmer puts delicious feed grain into one trough and water into another. Life seems good. You don’t need to forage, roam or exercise much; everything is laid on in this hotel-like environment.
Each day that goes by, you become more confident about the generosity of the farmer – you see him feed you, work hard for you – he obviously has your best interests at heart, right? So as time passes you grow more confident in this rosy view of the world – that is, until a few days before Christmas when you experience an unexpected event.*
This can be illustrated graphically – see graph opposite.
Although not always obvious, the turkey distribution can be seen in a variety of investing situations. If you owned Bradford & Bingley or Northern Rock junior debt in the years running up to 2008 or German Marks in the 1920s, you would have experienced the turkey distribution at first hand.
The turkey distribution lies at the heart of many fixed income investments. It is a very human desire to avoid the uncertainty and natural volatility of markets and life in general. Unfortunately people overpay for the illusory certainty of fixed income style pay-offs.
This is sometimes referred to as “reaching for yield” where investors naively focus on the promised interest rate but ignore the default risk. How well do we understand default risk on high yield bonds, leveraged loans or Greek sovereign debt? Behavioural finance research shows we find it hard to properly assess low probability risks*. Out of sight, out of mind is a powerful truth.
Whenever you appraise an investment, you should ask whether an investment has the characteristics of the turkey distribution. If so, you might want to ask yourself: could I be the turkey here?
We are now entering October and the nights are drawing in. Like they say on Game of Thrones, winter is coming. October has traditionally been a good month for equity market crashes. Everyone knows this and volatility may run higher in October. There is also a seasonal effect in the equity market. Historically the majority of capital gains in the equity market have been delivered between 31 October to 31 April.
If you’re sat on surplus cash, the rational move is to invest it. On average, the sooner it gets invested, the better. If you’re waiting for a market fall, you are engaging in a form of market timing. When it comes to market timing, there are 2 types of people: those that can’t do it and those that don’t know they can’t do it. Even when the predicted pull-back actually happens, people think the world has become scarier and they hold off from investing until the outlook is clearer (when prices are higher).
If you can’t face investing 100% of your surplus cash now and then seeing the market go down, there is a simple compromise. Formulate and stick to a simple plan to scale in over time – e.g. you could invest 1/12 each month to scale in over a year. The exact details don’t matter. What matters is that you overcome fear and get invested over time.