With Isa savings rates so low, it’s tempting to ask whether it’s worth holding savings as cash at all. Beyond its insurance value against a rainy day, many investors might say no, it’s just a means of exchange. But they’re wrong, says Société Générale’s Dylan Grice. “As an asset class, cash doesn’t get the attention it deserves.”
Perhaps this is no surprise. Textbook investing is all about accepting risk to achieve a decent return – who wants to invest in a dead asset that offers a zero expected real return (taking inflation into account)? But right now, there are three good reasons to hold at least some cash.
Valuation risk
Valuation risk, says James Montier of American fund group GMO, is “the risk that is involved in buying overvalued assets”. A value investor knows that, when assets get pricey, they should sell – because high asset valuations compress forecast real returns. In other words, the more expensive something is when you buy it, the worse your future return is likely to be.
Using data drawn from looking at the S&P 500 since 1940, GMO expects the US index to return 0% a year in real (inflation-adjusted) returns, if an investor puts their money in at this level. Indeed, says Montier, once expected returns are at or below zero, “investors risk seeing their investment halve over the next three years”.
So, while cash returns may be low (savers looking at instant-access accounts will struggle to earn more than about 1%-2% gross), the valuation risk pales compared with many other asset classes that don’t offer a decent enough reward for the risk you have to take.
So, concludes Montier, it’s “better to hold cash and deal with the limited real erosion of capital caused by inflation, rather than hold overvalued assets and run the risk of permanent impairment of capital”.
Fundamental risk
As Grice notes, “the reason many investors won’t hold a lot of cash is that they don’t trust central banks to play fair” with its value (by employing money printing or ‘quantitative easing’ combined with record low interest rates).
But, over time, nominal (non-inflation-adjusted) interest rates “have generally tracked the rate of inflation”. This effectively compensates an investor holding cash for any “ongoing debasement”.
For example, in the 1970s, when inflation was rampant due in large part to soaring oil prices, “the real total return to cash was actually on a par with bonds and equities”. On a risk-adjusted basis (taking volatility into account), cash “was much better than either” because its price is more stable. So investors hunting for a safe haven from inflation could do a lot worse than cash.
If we don’t get inflation, it doesn’t matter. As Montier notes, “cash is also a pretty good deflation hedge”. In Japan (which has flirted with deflation for two decades), from 1990 to 2011, “cash maintained its purchasing power in real terms”. Equities didn’t come close. Bonds were the best bet, but to have known that then would have required “foresight regarding the path of Japanese inflation”. Given no one had that, cash would have been a good way to hedge your bets.
Optionality
Montier calls this the “dry-powder value of cash”. Waiting for risky assets to get cheaper can pay off. As Grice puts it: “If US equity investors at today’s valuations are faced with a long-term return which is not dissimilar to that on offer to holders of cash, why wouldn’t they just hold cash?”