Why cash is a terrible long term investment

I’m sure we all know someone who thinks cash is king. Not because they feel it’s important to have excess cash available for liquidity purposes, but because of fear. Fear that if they invest their money anywhere else, they’ll lose it all.

For those of us with more experience and knowledge of how a stockmarket works, we see this as a fear that’s just as irrational as someone who won’t swim at the beach for fear of a shark attack. The thing about irrational fears, however, is that it’s very real to the person involved. And if we aren’t careful, they can spread that fear to others close to them, particularly if it’s a parent passing that fear on to their children. That fear can very easily extend from one generation to the next (and so on), unless education is used to help dispel the fear.

Let me say at the outset, I’m not referring to those who hold a small amount of cash for liquidity and cashflow purposes, but those who feel that cash is the only “safe” option to hold the majority of their capital.

So, why do I say that the fear of losing all your money if you were to invest it is irrational? Well, if you were to invest your capital across a diversified portfolio of the best companies in Australia and globally, the odds of you losing all of your capital are virtually nil. This is because the best companies have proven business models, generate exceptional profit year on year, and are typically market leaders in their chosen field.

If a succession of these companies were to go bust (and therefore have their share price reduce to cents in the dollar) then the economy as a whole would be in dire straits. Hyper-inflation would be rampant, banks would be failing under the weight of loan defaults from their customers, and that would mean your safe-as-houses cash in the bank would become virtually worthless. That’s the extreme apocalyptic view, and for the record it’s almost impossible to see happen (we aren’t Zimbabwe after all).

So what if we get the GFC mark 2 – which history tells us will happen at some point (there’s always been market corrections, right back to the tulip bubble in the Netherlands in the 17th century) – and share prices halve? Surely keeping a significant amount of cash available will help avoid the scenario of your capital reducing significantly? Only if you take the view that share prices won’t rise back to previous levels (and beyond) at any point in the future. History tells us that market corrections are mere potholes in the road on the way to an ever rising market. After all, that 1987 stock market “crash” doesn’t look too extreme now that the passage of time has dulled its effect:

The All Ordinaries Index over the past 30 years (FYI this is a price index, it doesn’t take into account dividends paid)

It does make sense to hold some short term cash for investment opportunities when the market dips, but it’s very difficult (nigh on impossible) to pick the bottom of the market, and human nature dictates that we’re far more likely to wait until the market has risen before being comfortable enough to invest again.

I firmly believe that you are better off buying the bank rather than lending to the bank (which is what is happening when you deposit money with them). Equities can provide the capital growth to outpace inflation, whilst providing the income (in the form of dividends) to provide for living expenses.

Whilst cash can provide the income you seek, the effect is that the capital gets eroded by the silent killer that is inflation.

How much $20 gets you over the years

As a simplistic example, say you invested $100,000 in a 5 year term deposit paying you 5% pa interest, with an annual inflation rate of 3%.

By year 5, the $5,000 interest payment you receive will buy you less at the shops than you could in year 1 (equivalent to $4,300 pa in today’s dollars), whilst your capital will reduce in purchasing power from $100,000 to $85,800 (in today’s dollars). You’ll still get your $5,000 interest payment and $100,000 capital at the end of the term, but the purchasing power will have reduced over the years, giving you effectively less to invest with going forward.

For this reason cash is a terrible long term investment.

It’s my job to work as my client’s financial ‘lifesaver’ to ensure that they swim between the flags and that they don’t get in over their heads.