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Cash as an Investment

By Francis Marais and Jan Vlok, 7 September 2017

The prevailing economic and market environment has motivated people to embrace cash as an investment alternative. What we are seeing is that individuals are making emotional decisions as a direct response to the adverse environmental challenges, and they often make costly errors in judgement due to their lack of understanding and/or the absence of concrete, reliable information.

Of course, when investment horizons are short term in nature, low-risk investments, such as cash or money market are fundamentally warranted, although better opportunities exist. However, when individuals invest for long-term real growth, it is important not to place too much emphasis on short-term movements. By definition, the investment is for the long term. Unfortunately, it takes time for individuals to see why they needed to persevere, but this usually only becomes clear after the fact. Hindsight is 20/20 vision.

The pros and cons of cash as an investment:

Pros

  • Does not have any drawdowns. There is no possibility for capital losses;
  • Presents options (though not in the case of fixed deposits). Provides trigger-pulling ability to try and get into risky asset classes when they are valued attractively;
  • Strongly related to the emotional well-being of the individual. An increasing number of investors exhibit a high positive emotional bias towards the perceived well-being that cash investments provide, as opposed to the same amount invested in equity or riskier investments.
  • Correlation benefits, but only when utilised within a portfolio, and not as a standalone investment. It is better to leave the cash allocation decisions to experienced and qualified portfolio managers of unit trust funds or collective investment schemes.

For some investors, education could be a tool to mitigate bad investment decisions. For instance, long-term investors could be informed of the disadvantages of cash (see below), and consequently their minds could be changed. However, some individuals exhibit emotional biases despite information and education efforts.

Although there are some benefits highlighted above, the fact of the matter is that there are unit trust funds and collective investment schemes available to investors which offer many of the same benefits, but without having to give up the opportunity to achieve real returns for these individuals. For instance, the South African Multi-Asset Income funds provide similar benefits through:

  1. exhibiting no material drawdowns (usually no drawdown on a three- to six-month rolling basis) or volatility;
  2. providing optionality as these investments offer daily liquidity; and
  3. providing many of the same correlation benefits within a portfolio of different asset classes as these funds are heavily invested in cash as well.

Cons

  • Historically, cash has been the lowest-returning asset class. In only one of the last 16 calendar years, has cash outperformed bonds and equities. This, quite recently, occurred in 2015, thereby exacerbating the bias shown towards cash of late. Cash has a low probability of producing material real returns. In a country where long-term inflation averages around 6%, most of the returns are decimated by the rising cost of goods and services in the economy.
  • Timing is a critical factor. When embracing cash as an investment alternative, one concedes to the timing of the markets, i.e. identifying the best point in time and the appropriate valuation levels to enter risky asset classes. This disadvantage is two-fold. One has to decide when to get out of the market (especially relevant for risky assets), which further decreases the probability that an investor will be successful. The best course of action is to leave it to the wisdom of the professionals. The intrinsic dangers are highlighted by the fact that if an investor missed the top five trading days on the JSE over the past 20 years i.e. 0.1% of total trading days, as a result of withdrawal, as opposed to remaining invested, s/he would have 28% less capital at the end of the period. This highlights the power of compounding and the importance of investor perseverance.
  • Exposure to single counterparty risk. When investing in a fixed deposit, an investor is exposed to only one counterparty (the bank). The risk increases exponentially by the fact that the counterparty could default or “go bust”, rendering the entire investment sacrificed. When comparing this to SA Multi-Asset Income funds as an alternative, these funds invest in a multitude of counterparties, which reduces the impact should any one of the counterparties default.
  • Cash/fixed deposit rates are low. When looking at what banks are willing to compensate investors for locking away their money, the rates are quite dismal. Investors simply are not sufficiently compensated for the term. A benefit of SA Multi-Asset Income funds as an alternative is that the portfolio managers are offered institutional rates, which trumps rates offered to investors at retail level. In part, this is why better returns can be generated through these funds. Another benefit is that investors can access these superior rates without having to lock away their capital, as would otherwise be the case. One last consideration individuals should keep in mind, is that rates on fixed deposits are quoted in simple interest terms (as opposed to compound annual rates), which inflates the perceived rate one would receive. For example, a simple interest quoted rate of 12% per annum over five years is actually equal to 9.86% on a compound annual basis. The math is simply as follows: [((1+0.986)^5)-1]/5 = 12% (to get to simple interest from compound interest and vice versa). Compared to yields offered on SA Multi-Asset Income Funds, investors aren’t sufficiently compensated for the opportunity cost assumed, as these funds offer attractive yields ranging from 7.7%-9% (Glacier Shopping List SA Multi-Asset Income category fund yields).
  • Missed opportunities. Being locked into an investment for a predetermined period of time – usually five years – gives rise to potential opportunity cost. When observing periods of material market downturn (drawdown in equity markets), it becomes clear that equity markets are quite efficient in recovering previous losses. For example, during the 2007-2009 financial crisis, the JSE/ALSI experienced a 45.4% drawdown, but managed to recover this massive drawdown in under two years.
  • Tax disadvantages. Individuals are only offered R23 800 interest exemption for interest received. All interest income over this threshold is taxed at the marginal rate. Given this fact and that money market/fixed deposits only produce returns from interest, it is a very inefficient investment from a tax perspective, considering that returns from capital gains (the main source of return in equity investments) will be taxed at a significantly lower rate. For example, if an individual is on the maximum marginal tax bracket and has used both their annual interest exemption and capital gains exclusion (R40 000), the rate at which additional interest income will be taxed is 45%, whilst additional capital gains will only be taxed at an 18% effective rate.

In summary, cash does offer some benefits, including downside protection, as no volatility or drawdowns are experienced. It also offers optionality or trigger-pulling ability when risky asset prices are attractive. However, as in the case of fixed deposits, an investor would have to pay excessive penalties on an early withdrawal. Cash investment is not an advantage: it has portfolio construction benefits as the asset class exhibits low correlation to other classes. It is only beneficial when used in a portfolio of different asset classes and not as a standalone investment. The reason why people have preferred cash as an investment destination recently, is that it offers emotional well-being.

The disadvantages are manifold and pronounced. A cash investment would ensure poor long-term real returns (if any), and necessitates good timing decisions into and out of the market, as in the case of risky assets. It would have dire consequences on total return if just a few good trading days on the Exchange were missed. It would need prolonged fixed periods, which gives rise to opportunity cost, illiquidity and penalties. Finally, the impact of tax makes a cash investment very unattractive, especially when an investor is taxed on the maximum bracket and when exemptions are exhausted.

Although there are a few benefits of cash, these benefits can be extracted through investment in a low-risk unit trust fund or collective investment schemes vehicles and funds in the SA Multi-Asset Income Category are good, viable examples of this. Investors will experience most of the benefits, without having to give up the opportunity of real returns. For investors exhibiting errors in judgement in relation to their investment decisions, i.e. flawed decision-making due to a lack of education or understanding, information dissemination and education could solve the problem. However, for individuals exhibiting emotional biases, education will not mitigate the issue successfully. In conclusion, there should be emphasis placed on viable alternatives to cash, which will not compromise the individual’s investment portfolio to the degree that a cash investment or fixed deposit could.

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