To many, cash represents an opportunity cost, an opportunity lost. These investors believe cash is a temporary holding medium between risk-assets, held unwillingly, often for a lack of better ideas.
That is a limiting, myopic view. Cash is a core asset class, not a blank canvas from which to create an investment. Sometimes – even over long periods – cash is a better investment than one or both of the other two core asset classes. Most times, even if it underperforms equities or government bonds, it still delivers positive, real returns with low risk of nominal losses – a unique, compelling trait of tremendous value.
Although cash is not a popular choice with many investors and often underperforms both equities and bonds, it has a valid role to play within a diversified portfolio.
No decade is identical, but history does rhyme. And for investors, long-term data should serve to compensate for inherent recency biases, particularly any anchoring to the “anti-cash” mentality developed over the last few years of financial repression (i.e. low interest rates).
In the only completed decade of this century, cash outperformed equities in real terms – all while not experiencing a single moment of negative nominal or real returns; a nice little feature to have had during the 2008 meltdown. Where the 1980s and 1990s were a roaring period for risk assets – both equities and bonds did very well – cash respectively returned five per cent and four per cent above inflation annually in each of those decades, and all with no fear of losses.
Perhaps of most resonance to the present is the decade beginning in 1950, the last time interest rates were as low as they are now. It is no coincidence that then, similar to today, low rates were the result of policy-driven financial repression, then in response to a staggering build up in government debt following the Second World War. In that period, cash outperformed bonds, and would continue to over the next two discrete decades (beginning 1960 and 1970, respectively).
Equities are well known to be risky. But it is wise to remember that bonds are also a volatile asset class. Paltry real coupon income did not compensate for the falling capital values during the long three-decade bond bear market beginning in the 1950s.
Furthermore, bonds – with fixed coupon yields – have “locked-in” rates of interest if you hold them to maturity; if you do not, and rates rise, you get punished with a capital loss.
At the moment, the UK inflation rate over the next 10 years, implied by the breakeven rate on index-linked gilts, is 2.3 per cent. The 10-year gilt yields 1.3 per cent. Therefore, even if rates were not to increase, you are still subject to a guaranteed real loss. In contrast, cash tends to be much more flexible, with returns on anything from simple bank accounts to sophisticated money markets funds rising along with base interest rates.
Admittedly, there are a number of demographic (e.g. ageing populations, declining labour force participation rates) and structural reasons (e.g. savings glut) to believe why rates – and therefore cash returns – may not rise again to pre-crisis levels.
However, in that case, any inflationary headwinds to the real return on cash would also be diminished, a fair compensation all else equal. Regardless, if policymakers are to be taken at face-value, we can reasonably assume that interest rates will be “normalised” at some level, safely above the inflation rate. That path will likely be more punishing for government bonds than it would be for cash.
At present, equity valuations are neither too expensive nor too cheap; of the core asset classes, they offer the highest relative expected returns.
Therefore, they form our most concentrated allocation in multi-asset portfolios. Our optimism for equities, though, is tempered by a number of economic risks and earnings headwinds, and leaves us guarded.
In addition, as of May 2016, the current equity bull run officially became the second longest in history. At some point, it will end. This partly explains our allocations to government bonds – which are in positive momentum; and inversely correlated to equities – even though they have a low expected return profile.
This brings us to cash. We have increased our cash allocation in recent years. One, it keeps “powder dry” for attractive investment opportunities and reduces volatility from potential risks of all kinds, including the geopolitical, such as the impending “Brexit” referendum.
Two, it is a core asset class. It may not generate much in the way of return, but it does not lose nominal value – the most effective form of protection if and when volatility for risk-assets increases. Finally, the current “low inflation” environment does not penalise those holding cash.