“By 3 methods we learn wisdom. First, by reflection this is noblest; second by imitation, which is easiest; and third by experience, which is bitterest.”
Confucius
Reading some of the financial literature over the past few months could easily lead one
to believe that as far as investment is concerned everything has changed (again); the end of the (investing) world as we know it is nigh – the whole of Europe is a disaster zone, the USA is not much better and who knows what is really going on in the East? Equities are dead and people should stay away from the markets (I guess by default that implies that people should invest in cash and maybe some bonds and property). And yet, while we have all been consumed with worry about the future of the markets, they have quietly gone about their business increasing in value and some, like the JSE, have even reached all-time highs.
Many investors, with the benefit of hindsight, also moved out of equities after the volatility in the markets in 2008/9 (realizing losses) and are now still sitting in cash; they have been too nervous about all the “noise in Greece” and are still waiting to maybe get back into the market again. Initially the strategy of sitting in cash might have seemed reasonable, rates were higher and at least there was no volatility…many of the banks have even been advertising their “good” rates on cash “investments”, thereby seemingly reinforcing the notion that it is okay to “invest in cash”. What people fail to realize is that every investment has some form of risk attached to it and there are times when even cash can be a high risk asset class. So if we need to be careful of falling into the same traps all over again, what are the traps and more importantly, why is cash (a potentially) high risk investment?
Perhaps a good starting place is to look at some of the risks involved with investment. What are they? The majority of people who are sitting in cash right now are there because of the volatility risk in the equity markets. For many, this volatility is a completely new (and frightening) thing. This is the risk caused by fluctuations in the prices of equities. It is the risk that causes people to lose sleep at night and that causes people to regret ever having invested in equity markets. It is not uncommon to hear things like “if only I had left my money in the bank…” Many advisors have also taken a path of least resistance and have allowed clients to call the shots. This has resulted in much money being switched from the equity markets to the “safety” of cash. Many investors have “classically” bought high and sold low in an attempt to remove the volatility risk from their portfolios.
But, if risk can be defined as the probability of losing money then investors sitting in
cash have, however, exposed themselves to at least 3 other major and possibly even
greater, risks.
The first of these is every long term investor’s biggest enemy – inflation! At an inflation rate of 6% per annum, R1000 today will be worth ±R548 in 10 years’ time and ±R300 in 20 years’ time – see table below for more figures and different inflation rates.
|
Value of R1000 at year end – inflation (%) |
|||
|
End of year |
6% |
8% |
10% |
|
1 |
R 942 |
R 923 |
R 904 |
|
2 |
R 887 |
R 852 |
R 818 |
|
3 |
R 835 |
R 786 |
R 740 |
|
4 |
R 786 |
R 725 |
R 669 |
|
5 |
R 740 |
R 669 |
R 605 |
|
10 |
R 548 |
R 448 |
R 366 |
|
15 |
R 406 |
R 300 |
R 222 |
|
20 |
R 300 |
R 201 |
R 134 |
|
25 |
R 222 |
R 134 |
R 81 |
|
30 |
R 165 |
R 90 |
R 49 |
If inflation is such an enemy, then what are the solutions? Statistics show that R100 invested in Jan 1960 was worth the following at the end July 2012 (before tax).
- Equities – R435 430 (±17.4% pa)
- Bonds – R17 568 (±10,6% pa)
- Cash – R17 444 (±10.4% pa)
(Source: Mark Seymour, PSG Asset Management.)
If your R100 had just kept pace with inflation over the period (8.3% pa) then it would be worth around R6000. Now while it might appear that even after tax, cash and bonds might have beaten inflation, this is certainly not the current scenario – our interest rates have been much higher in the past but cash rates are now around 1.5-2% below the (official) inflation rate (before tax)!
Every investor is exposed to inflation risk (where the growth on their portfolio is less than the rate of inflation) and there is a danger that their real wealth is seriously undermined by the effects of inflation. It is all very well to believe that you are safely invested in cash, earning interest of 4.5% per annum, but what about inflation and the tax effect! A 4.5% pre-tax yield can very quickly be reduced to around 2.5-3%pa after tax has been applied. Yes, the tax tables have changed and so too have the interest thresholds and investors should take advantage of these, however, investors with all their funds in cash (because of equity volatility) could be significantly poorer in a few years’ time! It is well established that equities have beaten (and will beat) inflation consistently over the long term. Every serious long term investor runs a greater risk by being out of equities than by being invested in equities.
This leads to the second (bigger risk) and that is timing. Some investors (and advisors) believe that they will sit in cash for now and will move back into equity markets as soon as the markets start to move upwards again. This is foolishness! Essentially this involves trying to miss the bad days and thereby only benefit from the good days on the market. The problem
with this type of timing is that no one has been able to repeatedly do this and in fact the research shows that the markets tend to move very quickly, often making big gains (and losses) on single days (in fact, after the sharp drops in 2008, the markets recovered with a speed that caught almost all by surprise and less than 4 years later, JSE All Share Index is testing new highs on a regular basis).
It is all very easy to get out of the market (for fear of them falling further) but the issue is then about when to get back in to the markets. Research published by Fidelity Asset Managers shows the devastating effects of being out of the markets. The research was conducted over a 15 year period from 31 December 1987 to31 July 2002 and compared an investor who remained in the market over the entire period (S&P 500 used as the benchmark) versus an investor that tried to time the market. The results are incredible! The investor who remained fully invested had an annualized return over the 15 years of 11.8%. By missing the 40 best days during the 15 year period, the investor that tried to time the market reduced the return to a dismal 1.6% per annum. In other words by missing the 40 best days (40 out of almost 3900 – just about 1%) the return was hammered. Instead of getting the funds to double every 6 years, the funds would have doubled in value every 45 years. Trying to time the markets is much more risky than just staying put in them.
The final of the 3 risks that cash investors face is that of interest rates. Interest rates have historically been higher but for some time now we have seen them at much lower levels (globally) and it appears that this might be the case for quite a while to come. Post-tax long term cash returns have not historically beaten inflation and it appears even less likely going forward. Cash is not the appropriate asset class for long term investors (despite some fairly persuasive and misleading advertising by some of the banks).
In summary then, “things have not changed”. Equities are not “finished” they remain the “business engine” of the economy. Exposure to them is essential for long term investors. Cash may appear the safer option right now but you could be exposing yourself to much greater risks – there are times when cash could be a high risk investment! Don’t learn this by experience (again)!
