Fraudulent cash magic

This article was originally created for Livewire markets

In Homer’s epic poem Odysseythe beautiful Sirens attempt to lure sailors off course by mesmerizing them with their song and causing them to crash into rocks and land.

Does the allure of cash have a similar effect on investors today?

With some banks now offering north of 5% on savings, cash and cash products have re-entered investors’ minds after missing so many years of ultra-low interest rates. This is good news for investors. It’s also good news for the markets. The “hunt for yield” when interest rates were zero caused harmful distortions in the capital market.

However, higher cash interest rates bring their own risks. Five percent might be better than zero percent, but cash is still a terrible long-term investment. And that’s a lesson many investors are learning the hard way.

The illusion of current cash returns

In a financial world where interest rates have been low for more than a decade, it’s easy to get excited about the opportunity to earn what appears to be a decent return on cash. High-yield savings accounts, certificates of deposit (CDs), and money market accounts currently offer annual percentage returns in the 5-6% range and, in some cases, higher. Those yields appear competitive with the last decade of low rates, leading some investors to favor cash as a safe and affordable means of growing their wealth or as a less risky alternative to stocks.

Comparing cash returns over time

While the immediate cash returns look enticing, a closer look reveals a different story. Cash rates are higher at the moment because inflation has been higher – meaning the real rate of return on a cash investment is close to zero after accounting for inflation. As you can see in the table below, this has always been the case with cash. At best, you will retain your purchasing power. If inflation goes down, interest rates will go down too, and your 5% return will be 3% or 4% before you know it.

Stocks offer a much better real rate of return than cash and cash products over long periods of time. Inventory has been created average real rate of return ranging from 6% to 7% per year over the past 100 years. You were able to get these returns more inflation by owning these real assets.

Big differences in the long run

Four to six percent may not sound like a huge difference. But when the power of compounding works its magic, the differences deepen over time.

Consider two hypothetical investors: one who places $10,000 in a high-yield savings account with a 5% annual return, and another who invests the same amount in shares in an exchange-traded fund (ETF) with a 10% annual return (assume inflation of 5 % plus 5% actual return). After one year, the cash investor earns $500 in interest, while the investor’s investment in the ETF grows to $11,000. That’s not much of a difference in a year, so might as well prefer a safe haven of cash?

Fast forward ten years and the investor’s $10,000 in cash has grown to $16,386. It’s not buying anything more than it was. The investor’s investment in the ETF grew to $25,937 – a much larger difference than the cash return – showing the real benefit of higher returns over time and providing a real rate of return after adjusting for inflation.

Compounding Conundrum

Now let’s take this comparison to a longer time frame, say 25 years. A cash investor’s $10,000 grew to $33,864, a seemingly impressive feat. However, the ETF investor’s initial $10,000 has now grown to a whopping $108,347. The difference between the returns of the two investors is now strikingly large. After 30 years, a cash investor would have $43,219 versus $174,494 for ETF investors.

This phenomenon is the essence of folding. While cash investments can provide an attractive return in the short term, their low real rate of return limits the potential for long-term growth.

Security costs

Many investors understand the math above. Their strategy is not to invest in cash for the long term, but to park their money in cash until the outlook for stocks improves. This is completely understandable. When bank interest rates hit 5% for the first time in mid-2023, equity markets were in turmoil. With recession and inflationary turmoil looming, who wouldn’t be attracted to the security of a guaranteed bank account?

Well, me for one. The “wait until the coast is clear” approach is the most pervasive, wealth-destroying and unshakable investor mindset I’ve seen. And there is no better example than the last 12 months.

Are you feeling a little better about the world? Inflation seems to subsidize. The economy seems to be holding up well. The RBA talks about the potential for rate cuts.

Well, I have bad news for you. Share prices have soared since then, making it 20% more expensive to buy back into the market than when you were worried. Stock markets in the US and Australia are at all-time highs.

Combine that with the prospect of lower cash rates and the investor is hit with a double whammy that could potentially cost years worth of earnings.

The allure of cash may be tempting today, but…

Of course, cash plays an increasingly important role in most investors’ portfolios. Their priority should be an asset allocation plan (this can change as the investor reaches different stages in their life, and should include an increasing allocation to liquid assets such as cash over time).

However, once you have a plan, you need to stick to it, through and through. Odysseus (from our famous poem) went so far as to tie himself to the mast of his ship and make the sailors plug their ears with beeswax so that they would not be distracted by the singing of the sirens. Odysseus thus managed to sail unscathed through the notorious straits between Sicily and Italy. While we don’t recommend tying yourself to the mast anytime soon, this story is worth remembering if you ever consider faltering with your investment strategy in future times of market panic. The allure of money in times of need is nothing more than that, a lure to be avoided.

Reference: Sirens in the Odyssey

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