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Why cash can be the riskiest asset of all

When you consider the biggest risk to your wealth.

Every investor would have heard of equity and listed property referred to as ‘risk assets’. They would also have seen a graph which shows the relative risk of different asset classes, with cash at the bottom as the ‘lowest risk’ and equity at the top as ‘highest risk’.

Intuitively, this also makes sense. Cash in a bank is pretty safe, and to a certain extent is even guaranteed by the central bank. Unless there is a serious meltdown, you’re unlikely to lose it.

Shares, on the other hand, are a lot less secure. Anyone who was invested in the stock market at the time of the 2008 crash can attest to that. The FTSE/JSE All Share Index fell over 40% from its high in May that year to its lowest point in November.

However, there is a major caveat to this that easily gets overlooked, and often to an investor’s detriment. When people talk about risk in this context, they are talking about volatility in asset prices and the potential for a short-term loss of capital.

That’s certainly appropriate if you are putting money aside that you might need in the next year or two, but it’s far less so when you’re investing over the longer term. When your investment horizon extends over ten or 20 years or longer, there’s a far more serious risk to your wealth than the day-to-day ups and downs of asset prices.

“The main investor risk lies in inflation,” says Graham Tucker, manager of the Old Mutual Balanced Fund. “Inflation quietly consumes the spending power of your hard-earned savings and you don’t notice it that easily until it’s too late.”

He points out that many people don’t realise just how much inflation eats away at their wealth. The graph below illustrates how the value of R10 000 decreases over a 30-year time period at different inflation rates.

Source: Old Mutual Investment Group, MacroSolutions

What this shows is that even at an inflation rate of just 3%, the value of R10 000 would diminish to the equivalent of R4 000 in 30 years. At the upper end of the South African Reserve Bank’s target range, that R10 000 reduces in value to the equivalent of just R1 700 in today’s money over the same period.

“If you experience a higher rate of inflation due to rising education or medical costs, it has an even larger impact,” Tucker points out. “At 9% inflation, your R10 000 today is worth only R750 in 30 years time. It’s fair to say that inflation is a long-term investor’s true nemesis, and its a relatively silent one at that.”

Given this reality, the perceived safety of cash takes on a very different complexion. This is because while your money in the bank might never decrease, it is not going to increase much in real terms either.

“We’ve analysed the long-term experience of various asset classes and arrived at a few indisputable conclusions,” Tucker says. “The return from cash in South Africa over the last 88 years has been 6.9%, compared to inflation of 6.2%. That is before tax. Therefore cash in the long term is not the answer.”

To combat inflation, what investors need is exposure to higher growth assets such as equities and listed property. As the graph below shows, over the same 88-year period local equities have produced real returns of 7.8% per year on average.

Source: Old Mutual Investment Group, MacroSolutions

“One of the problems with these growth assets is that they are often termed risk assets because they display volatility,” Tucker notes. “But volatility is not the risk that long-term savers face. It is inflation. Volatility may be uncomfortable and from time to time as equities do fall in value, and if you have a short-term time horizon that can be problematic. But even in retirement most investors still have a multi-decade time horizon and need exposure to assets that will grow ahead of inflation.”

What makes this argument even more compelling is that the longer you stay invested, the less volatility plays a role. In fact, over the last 58 years, holding equities for more than five years in South Africa has never been a risky strategy.

Source: Old Mutual Investment Group, MacroSolutions

“What history shows us is that in the very short term of a day or a week, the chance that you could have lost money by holding local equities has been extremely high,” explains Tucker. “But as we extend our buy and hold period to years, that chance of losing money decreases rapidly.”

Time, in other words, has the effect of smoothing returns.

“The direction the market takes in the short term is almost equivalent to a coin toss,” Tucker says. “The factors driving markets in the short term are noise and sentiment. However, over the long term fundamentals and starting valuations play a for more important role.”

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Some people fear the uncertain profits of an investment in a share portfolio, so they take the certain loss of spending power by investing in interest-bearing instruments. If we can describe a situation from the angle of the effect it has, then an investment in bonds, money-market and cash act as subsidies to the income of mine workers and social grant recipients.

The income of the mine worker and social grant recipient rises to keep up with inflation, while that of the saver does not. A mine worker will be able to buy a loaf of bread in 20 year’s time, while the saver won’t be. Inflation acts as a conduit to move spending power from savers to spenders. I have witnessed how a person with a lump-sum equal to R30 million in today’s money, had to survive on a SASSA grant after 25 years, because she invested in cash instruments.

Inflation is both a threat and an opportunity. It is a threat to the value of savings, but an opportunity if you borrow to invest. Gearing increases risk but as we have seen, the lowest risk alternative brings about a certain loss. Inflation forces us to take risks.

We can come to the conclusion that savers who avoid risk, are subsidizing the income of mine workers, and that is a certainty.

Agree with much of what you say except borrowing to invest.
Gearing is serious gambling rather than reasoned investing.

Still, yes the rewards are magnified, as are the losses. Some people view that as a risk worth taking and best of luck.
Most people who leverage in my opinion dont fully appreciate just how much they can lose or even the fact that they can lose.
I am old enough to remember how enamored people were with flip-flopping properties. Whenever I asked them what are they going to do with the properties if they cant find a buyer (which is exactly what happened with some), they looked at me like I was stupid, emphasizing the point that they never even stopped to consider the risk they were taking.

Power and luck to people who want to gear, but eyes wide open hopefully.

I am not so brave and will stick to the old boring method of using surplus cash and income for investment.

Agree fully with this article. Problem is since January 2014 fixed income assets are starting to outperform many top balanced funds. The communist rhetoric seems to be making this worse.

A major problem is also making the transition from the company pension fund where you either need to encash equity assets or hope that you can buy buy in at an acceptable price after all the section 14 transfers are done. A feature article on how to manage this event would really be helpful.

Next question will be whether to stay in balanced funds or rather have a mix of pure equity funds and enough income funds to cover a few years living expenses.

Readers should remember this article pertinently talks about how listed property and equity investments over five year or longer terms result in positive returns over and above the devaluation effect of inflation on the buying power of your increased investment amount. Crucially this also implies that the ordinary man in the street do not cash in his / her property or equity investment during down-turn performance phases(when the value of your investment on paper is down), but to stick it out until the market has recovered and you have made a healthy positive return above the inflation rate (of say a gross return of 13 to 15% on average per anum over the five year or longer investment term). The timing of cashing out from your equity investment is just as important as the timing of investing into equities.

Just make sure your equities are offshore and not in SA.
Over 3 years cash has beaten local equities handsomely. Old Mutual must be feeling the pressure….

Doubt Old Mutual are feeling the pressure.They are still taking their cut and their brokers are still getting their commission.It’s their policy holders who are feeling the pressure!

The MSCI World Index, SP500, FTSE100, Eurostox50 are listed as ETF’s on the JSE. Soon the Nasdaq 100 index, the star performer of all international indexes, will also be available to local investors in the form of an Exchange Traded Fund. That pretty much removes the incentive to invest offshore.

Weigh up the risks of having your funds offshore, out of reach of the socialist ANC politicians, against the risk of your offshore investments going into probate if you die, or taking the risk with an international bank that is riskier than local banks.

When it comes to yield, performance and cost, for the average investor there is no reason to go offshore. The JSE offers good opportunities. Those who say that the JSE does not offer opportunities are being disingenuous because those international opportunities they punt, are listed locally as well. Don’t confuse poor performance in Rand terms, with a Rand strengthening against the dollar.

By running away from the local political risks, you may be running into the risk of probate and a banking failure overseas. Out of the frying pan into the fire so to speak. The risk you do not anticipate is always the one that destroys you.

For the professional traders who use gearing it is another story. Some International trading platforms offer brokerage rates at a tenth, and interest rates that are a third of what is available locally.

I don’t really agree with this. Risk implies that there is some uncertainty involved. Risky means a lot of uncertainty. When investing in cash instruments there is actually very little uncertainty.

Let us say we invest R 2000 000 (two bars) in a on year fixed deposit at 7.75%. This is realistic. At the end of the period we have 2000000*1.0775 rand = R2155000. Of this amount R23800 is tax free. Thus we pay tax on R155000-23800 or R131200. This is paid at 41% i.e. we pay R53792. Thus we have R2155000 – R53792 = R2101208 over after tax. Let us say the inflation rate is 5%, this money will be worth R2101208/1.05 = R2001150 in one years time.

Mathematically something like this:

(2000000 + (2000000*0.0775) – (2000000*0.0775 -23800)*0.41)/1.05 =R2001150

Basically your capital is stagnant in terms of buying power. If you are living off your income, you are effectively consuming your capital.

Now one can ask what variables in the equation can change. I don’t mean that they are different for different people but rather they are not constant over the time (one year).

The interest rate is fixed at 7.75%
The SARS tax free allowance is fixed at R23800
The marginal tax rate of 0.41 or 41% is fixed for the year
Inflation can go up or down especially as it affects you.

Let us say that the standard uncertainty (uncertainty as a standard deviation) on inflation is 1%.

Now we calculate the confidence limits on the value of the money after one year using a Monte Carlo simulation:

Results from Monte Carlo simulation:
Mean sd Median MAD 2.5% 97.5%
2001332.02 19063.85 2001193.22 19009.15 1964458.64 2039229.47

We are 95% confident that the buying power of the money will be between R1964458 and R2039229 in today’s money.

Please note you may disagree with the inputs into the model but this is not the same as uncertainty.

Therefore, this is really not that risky.

There is certainty that you cannot draw a pension at 4% of your capital without reducing the available capital. The uncertainty is about whether you will outlive your capital or not. The younger generation face even more uncertainty, better to try and preserve your capital so that your children can get some help along the way.

sorry if i am not aware of any new tax legislation, but why would one pay tax of 41% on an annual income of R131200 ? am i missing something here ? Thanks

Karl- obviously not. The scenario I took was one saving for retirement on the maximum marginal rate. The rate would be 18% if that was your sole income.

If we change the tax rate:

Results from Monte Carlo simulation:
Mean sd Median MAD 2.5% 97.5%
2030073.69 19339.23 2029911.43 19335.28 1992799.33 2068527.40

The 95% confidence limits for the value of the money after one year are 1992799 to 2068527.

Marginally different, yes, but the purpose was to demonstrate that the investment is not that risky i.e. uncertain.

Hmmmm, take off Old Mutuals fees and you just about right back to cash returns :-),

The Dow Jones had zero growth for 16 years from 1966-1982 and there are numerous other examples. SA balanced funds had 3-4% return over the last 3 years with Global Balanced funds about 5% over the same period. Global Real Estate was 0.5% over 3 years. Really difficult for people in retirement with LA’s that need monthly income. An individual with limited knowledge would do better by creating his own mix of Cash, Bonds, Equity and Property. Time for Asset Managers and Financial Advisers to admit that all is not well. For those with an investment horizon of 88 (or even 44) years the choice is obvious but older people may enter a phaze where Stock Markets have zero growth for the rest of their lifespan.

Very good point Thesas.

Where you are in the investment/life cycle is crucial.

This is why this old re-hashed article is so poor.

Cash is not risky.

While the writer indirectly acknowledges liquidity, houses and certain shares also carry market risk: you may own beautiful, valuable assets, but the market may be thin just when you want (or worse, need) to sell them.

That’s why spreading eggs in different baskets (asset classes) is so important.

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