The Wealth Spa

Top 5 Secrets Why Cash is Not Safe

Posted on 05. Jan, 2009 by Elizabeth Potts Weinstein in Finance

In this turbulent economy many people are fleeing the stock market (or selling low) and sticking their money in cash.  While I do recommend cash (such as savings accounts, CDs, and money market accounts) as appropriate for short term goals (next 3 years), investing in cash is the wrong choice for long term (10+ years) goals, such as retirement.  

Cash seems safe because your principal stays the same (assuming FDIC insurance holds true, etc.).  But there are risks in keeping your money in cash over the long term that many investors are forgetting, especially when the stock market seems so high-stress and risky.

Before you sell the stocks and mutual funds and flee to cash in your retirement accounts, check out the following 5 secrets of investing for the long-term.    

Secret #1:  The up-and-down risk of the stock market (Risk of Volatility) is not your only risk of investing.  

When we think about the risks of investing, we usually think about the risk that a stock, mutual fund, bond, or commodity will be up or down in any particular year – that’s the Risk of Volatility.  Unlike cash investments, the principal, or value, of any equity may be up or down, perhaps even by double-digit percentages, each year.  As such, we cannot depend that our equities will be worth any particular amount at any particular time, in the short run.   

But there is another dangerous risk lurking to catch investors, especially conservative investors – the Risk of Inflation.  Simply put, inflation is the risk that the dollar under your mattress will not purchase as much in the future as it will today.   So every year, that dollar, or the principal in your savings account, looses true value.  

Secret #2:  Inflation is your problem if your goals are decades from being completed.

Since the mid-1980’s, inflation has averaged between 2-3% per year.  However, in the late 1970’s and early 1980’s, inflation went up to 13% per year (before the Federal Reserve was able to bring inflation under control).  Hopefully the Federal Reserve will be able to keep future inflation to a minimum – but I don’t create a financial plan based on hope, I create a financial plan to account for the worst-case scenario, just in case.

For example, let’s assume you are planning for retirement, a long term goal.  Yes, retirement is a long term goal even for those of you who are already retired – because if you retire today at age 65, you need to provide for your income at age 95, which is 30 years away.  

Let’s assume you want to live off of $60,000 per year in retirement – how much do you need in 2026 to provide for that $60,000/year lifestyle?

• At 3% inflation, you need $108,000
• At 5% inflation, you need $159,000
• At 7% inflation, you need $232,000!

As you can see, even regular inflation is a risk to whether you can provide for your lifestyle – and high inflation is the monster stalking your future goals.

Secret #3:  Invest primarily in equities for your long term goals – because over the long term, the Risk of Volatility is low, while the Risk of Inflation is high.  

Over the long term, or time frames over 10 years, historical real rates of return of equities (stocks) are rather consistent – between 6-7% averages per year – with a small number of time periods seeing a loss.  At 20 years, historically there has not yet been a time period where stocks took a loss (and only a few where stocks broke even).  In other words, the Risk of Volatility is likely to be low, when we are looking at time frames of 10-20+ years.  

However, as we saw in Secret #2, the Risk of Inflation, that we will need more dollars to buy the same lifestyle as today, is high, even if inflation is only 3% per year.  To make sure that our investments grow to meet, if not beat, inflation, we must invest in a way to generate greater returns.  And, since we are less worried about the Risk of Volatility over long time frames, we should be comfortable with investing in equities, to provide that greater return. 

Secret #4:  Inflation-Indexed Bonds are a good bond strategy when inflation is uncertain, but they do not replace equities in your portfolio.

Inflation-indexed bonds, such as TIPS and I-Bonds, were devised by the federal government to provide protection against inflation deteriorating the value of an underlying bond over time.  

In a regular bond, we purchase a $1000 bond that pays a 4% coupon.  Each year we receive 4%, and when the bond “matures,” we receive the underlying principal back, or $1000.  We may purchase the bond for $1000, or may purchase the bond at a discount.  If over that time we have had inflation, even though we receive our $1000, it may only buy $900 of goods, for example.  

In TIPS, however, the federal government determines a value for inflation twice per year, and adds an inflationary amount to the principal (to be paid at the end) and the annual interest.  Sounds great, right? 

But there are a few missing pieces:

#1 – The interest you are paid on a TIPS bond is less than a regular bond.  So, the money you will receive is already discounted by the fact that the TIPS bond might pay higher interest later.  The TIPS buyer is only ahead if inflation is much higher than expected (and thus was not factored into the original price by the market of buyers).  

#2 – You owe taxes each year on the inflationary amount (even if the amount is not paid out to you).  So, since you have to pay taxes on the inflationary amount, you are actually receiving returns lower than inflation by a bit each year.  

*I-Bonds defer the tax, but the tax on the inflationary portion is still owed when the bond matures.  

As such, TIPS are a great way to diversify your bond portfolio, and protect your bond portfolio against unanticipated high inflation.  However, they are no replacement for equities, since TIPS will never be able to beat inflation.  

Secret #5:  When investing, first determine your primary risk, then invest to combat that risk. 

When you are trying to decide how to allocate investments, first determine your greatest risk – is it the Risk of Volatility because your time frame is short, or the Risk of Inflation because your time frame is long?  

If your time frame is short (5 years or under), the Risk of Volatility is greater than the Risk of Inflation – you can likely predict inflation over the short term, but not stock market fluctuations.  As such, you are better off in cash, cash investments, and bonds.

If your time frame is long (10+ years), the Risk of Volatility is less than the Risk of Inflation – you can likely predict the return on equities, but inflation over the long term is unpredictable.  As such, you are better off primarily in equities, with some bonds and cash for diversification purposes.  

Photo courtesy of sciondriver via Flickr.

Related posts

• Investing Secrets: You Can’t Beat the Market (but who cares?) (12)
• There is no such thing as a risk free investment (1)
• How to Pick an Investment Part 4: Less Fees Is More (1)
• How to Pick an Investment part 1: Buy What You Want (0)
• Are Hidden Risks Sabotaging Your Investment Plan? (1)

Tags: cash, conservative investors, economy, Goal, inflation, invest, investing, investment, retirement, risk, savings account, stock market risk, stocks