Principles of Wealth #24*

Tuesday, January 22, 2019

Delray Beach, FL.- The banking industry promotes the idea that money stored in cash instruments (such as saving accounts, CDs, and money market funds) is safe money and a riskless financial strategy. But it is not true. Cash, like every other asset class, has risk.

On Saturday, Ted reads an article in The New York Times predicting that the president’s new tariff plan will decimate international commerce. Sunday morning, he reads a WSJ article pointing out that the stock market is dangerously overvalued with an average P/E ratio for the DOW of 25. At noon, he reads an essay by an economist he admires that points out that US debt is now higher than it has ever been.

He goes to bed feeling uneasy.

Monday morning, he calls Joe, his stockbroker. “What’s going on with the market?” he asks.

“You’ve seen the numbers?” Joe replies.

“What numbers?”

“It’s down.”

“How much down?”

“About 10%.”

“Is that bad?”

“It’s not good.”

“And my account ?”

He hears the tapping of fingers on a keyboard. “You should be relatively okay,” Joe says. “Your portfolio is very conservative.”

A bit more tapping. Then, “You are down just a bit more. Around 11.5%.”

“Shit,” Ted says. “I knew this was going to happen. What do you think I should do.”

“That depends on how you feel about the future. Our analysts believe this is a dip in a long-term bull market.”

“I don’t believe that,” Ted says. “Sell.”

“Sell everything?” Joe asks.

“Everything.”

“And do what with it?”

“Just leave it in cash.”

The tapping again.

“Okay,” Joe says. “You are out. Your money is sitting in cash.”

“Good,” Ted says “I feel better.”

“Then you made the right decision,” Joe says. “What could be safer than cash?”

Ted feels safe now because he believes cash is the safest way to store money. Tucked away in a federally insured savings account, earning a guaranteed rate of interest, he figures its value can only go up.

There is no doubt that cash does provide a significant level of safety, and that having a good stock of cash available to invest is a very good thing. But that doesn’t mean cash is completely safe.

The risk – the obvious risk – is inflation.

In economic terms, inflation is defined as a steady increase in the price of goods and services over time.

When the prices you are paying for food and rent and manicures increase at the rate of 10% a year, every dollar you earn becomes 10% less valuable every year.

We don’t think of it as dollars getting weaker because that is an abstraction. We think of it as things getting more expensive because that is what we are experiencing. And normally it’s preferable to think in concrete terms. But when you are thinking about currencies, it is helpful to understand both sides of the truth. It’s helpful to understand the effect of inflation on the dollar.

As I’m writing this, the rate of inflation is fairly low and has been low for some time. When inflation is low – say, 2% – its negative effect on the dollar is also low. If, per this example, you have your cash parked in a money market that is giving you a 2% return, there is no negative effect on your cash savings. The value of each individual dollar in your account is degrading by 2% a year, but that is equalized by the 2% you get from the bank.

There are times when the rate of return on cash savings is greater than the rate of inflation. If, for example, your savings account is giving you a guaranteed 3% return and the rate of inflation is only 1%, the value of your cash account would be increasing by 2% a year.

In the United States, the historical return on cash has been 3.4% (based on the US Treasury bill). Today, you can’t get that much. If you put your money into money market accounts and short-term Certificates of Deposit (CDs), you can get 1% to 2% (if you are lucky). But most savings accounts are going to give you a return of about half of 1%.

What about inflation?  Most official sources peg the current rate of inflation at about 2.5%, which is more or less its historical average. But if you look at a chart of historical inflation rates, you’ll see that they have ranged from a low of -10.3% (1932) to a high of 18.1% (1946).

Putting aside these extremes, another look at the chart would indicate that inflation rates tend to move in stretches of 4 to 7 years. There have been four periods when inflation has been at zero or negative (early 1930s, early 1950s, early 1960s, and 2008 to 2015), two periods when it has been in the 3% to 6% range (1966 to 1972 and 1982 to 1991, with a one-year dip), and one long stretch (1973 to 1981) when it was considerably higher, averaging nearly 10%.

So what does that mean?

* If your money is in cash during a time when inflation is low, the danger (cost) of having it in cash is also low.

* If your money is in cash during a time when inflation is moderately high (3% to 6%), the danger of having it in cash is moderate.

* If your money is in cash during a time of high inflation, the danger of having it in cash is high.

Ted feels good about his decision to take his money out of the stock market and put it in cash. So let’s say he decides to put his cash in a 10-year CD where he will get a 2.5% return. If inflation stays low during those 10 years, he’ll have made a safe decision. If inflation averages 4% during that time, he will have gotten another 10% to 15% poorer. And if inflation jumps into the range it was in from 1973 to 1981, he will have effectively decimated his wealth.

And that’s to say nothing of what could happen if inflation gets crazy, which some economic analysts believe is possible.

The prudent wealth builder views cash as a financial instrument that provides a good level of safety but also a not insignificant level of risk. Ted should expect to get from cash its natural return of about 3.4% and understand that to mean about 1% after the cost of inflation.

He should keep that meager return in mind. He should also recognize the immense power of cash when the dangers have passed and new opportunities are abundant. And most importantly, he should recognize that inflation is a bêtefarouche whose movements are wild and cannot be reliably anticipated – and, therefore, he should be very careful about long-term commitments to it.

* In this series of essays, I’m trying to make a book about wealth building that is based on the discoveries and observations I’ve made over the years: What wealth is, what it’s not, how it can be acquired, and how it is usually lost.