Have you got too much cash?
This may sound ridiculous – could there be a more first world problem?
But having too much cash sat idle in a portfolio is a common problem, one I see a lot in my coaching.
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, paralysed by indecision and the endless choices available.
Don’t get me wrong, its important to have some cash. This could be say 3 – 6 months spending held in a separate bank account 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.
And if you are retired, its also helpful to have some extra cash (or government bonds that can be turned into cash easily) so that you are never a forced seller of shares to fund your living costs. If you have enough cash or gilts (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). You want your money to be working hard for you, not slacking off taking fag breaks, reading The Sun and wolf whistling inappropriately at passing women.
Buy to let landlording can provide a successful vehicle for wealth-building. But, 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, as many people found out the hard way in 1981 when UK interest rates hit 17% and 1992 when they briefly hit 15%.
Real estate has a couple of psychological advantages over stocks. People love 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 shares have easy marketability should only be an advantage for the rational investor and never a drawback. A market price for a share provides an option that can either be ignored or used.
People fear the feelings of loss and regret they will experience if they buy shares 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).
The purchasing power of cash is falling every day as a result of inflation and tax. 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.
With every day that goes by, the real value of your cash is shrinking like an ice sculpture at a party.
Here’s the problem. The return on cash 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 deliberately trying to engineer inflation into the system to erode the real value of their debt burdens.
Please don’t blame governments for this. They are only doing what their masters (us) 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 borrows to make up the difference. Unfortunately things got a bit out of hand on this front, so governments are 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. 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.
Investing is full of paradoxes. One paradox is that safety is an expensive illusion. The flipside of this is that productive risk assets (shares, property) may be safer than they first seem.
The beauty of shares is not that they are 100% safe (there is no such thing). Rather it is that their dangers are obvious to everyone. In the last 15 years, we’ve seen 2 bear markets where shares roughly halved from peak to trough. People fear this volatility. But the good news for us long term investors is that the game loaded in our favour. And we savers should hope for lower equity prices rather than fear them.
Cash is a form of fixed income investment…as are gilts and corporate bonds. Fixed income does what it says on the tin. The income you get (the interest) is fixed and you know what its gonna be in advance (not very much these days).
But there is a problem with fixed income investments, especially higher yielding income investments such as corporate bonds, P2P lending or building society bonds. These 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.
You have a fixed “income”. Every day, the farmer puts feed grain into one trough and water into another. Life seems good. Everything seems certain. You don’t need to forage or roam 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 that fixed income promises.
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 the default risk on high yield bonds, P2P lending or Greek government bonds? Behavioural finance research shows that we don’t properly assess low probability risks*. Out of sight, out of mind is a powerful truth.
So ask yourself whether an investment has the characteristics of the turkey distribution. If so, ask yourself whether you could be the turkey here?
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, that’s 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.
If you can’t face investing 100% of your surplus cash now and then seeing the market go down, there is a simple compromise. Commit 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 get unstuck and get invested over time.