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The Economic Dynamics of Cash
We've dove into the concepts of wealth, asset types, and risk, but you might be wondering why these concepts are crucial. More specifically, why should you bother with investing if your goal is simply to preserve your wealth? The popular phrase "cash is king" may, on the surface, make it seem like holding onto money is the safest strategy. However, this view falls short when we understand the economic dynamics of cash.
In the past, our currencies were anchored to a hard commodity like gold. In times of crisis, wealth holders would hoard gold, and subsequently increase its demand, causing the price of goods and services to fall and the price of gold to then rise. This system created a liquidity trap, where wealth was no longer being funneled into businesses, ideas, or production, all while wealthy individuals became wealthier during dire times. Thus, we shifted away from the gold standard and adopted inflation targeting.
In most developed economies, the target inflation rate is approximately 2%; unproductive cash, therefore, loses about 2% of its purchasing power each year. Over a decade, a million dollars held in cash depreciates to roughly eight-hundred thousand. This erosion becomes stark over extended periods: a million dollars today will be worth less than four hundred thousand in 50 years, assuming it wasn't earning anything or being consumed.
Central banks, the entities controlling money printing, ensure that cash is inflationary by design. Inflation, in essence, is a tax on unproductive capital.
So, how do we mitigate this "tax"? The answer lies in the ownership of companies (i.e. equities), a strategy employed by sovereign wealth funds, pension funds, and other long-term institutional investors that hold more than 50% of their capital in equities. When you own a company, you own a tangible portion of its continuous production of goods and/or services. Your future profitability and income stream is not in a fixed cash dollar amount but rather in the actual value of that production as it is being sold. As the value of these goods and services goes up with inflation, so does your profitability — owning equities therefore serves as a great hedge against inflation altogether.
The affluent grow their wealth because they save for the future. We all have long-term goals – our future liabilities. If these liabilities are long-dated, we need to manage our assets accordingly. Investing is thus not just for preserving asset value against inflation, but also ensuring that you can meet your future liabilities/goals. It's about creating a passive income stream, which we can reinvest for greater future income if we don't need it immediately.
How Much Cash Should You Hold?
While cash isn't king in wealth management, it is at the same time necessary for emergencies. Having an emergency cash fund, approximately six months' worth of your monthly expenses, gives you a reliable safety net. This fund, combined with enough cash to cover foreseeable expenses over the next few years, should suffice for most individuals. However, for larger expenses like asset purchases or starting a business, you'll need investments that are liquid enough to bridge the gap.
A Word on Gold, Bitcoin, and Other Non-Productive Assets
As we've moved beyond the gold standard, we transitioned into using the USD to price goods and services. While USD isn't an excellent store of value, as inflation is by design, true wealth is found in owning productive assets – assets that can consistently generate future returns, irrespective of currency or gold prices. In managing your assets, prioritize productive assets like equities over non-productive ones like Gold & Bitcoin for this very reason.
However it is very important to remember the importance of diversification when doing so.
Understanding High-Yield Cash Deposits
Currently, short-term loans like deposits and money market funds yield over 5%. This might suggest cash is productive in the current environment. However, remember, interest rates rose from 0% to 5% due to higher-than-target inflation. We're only recently seeing the benefits of short-term rates exceeding inflation, but this environment may not last long.
Furthermore, the risk of uncertain future returns (reinvestment risk) comes into play. Holding cash only offers clarity on what return we'll see in the immediate future, not the long term. Thus, while you might enjoy a 5% yield over the coming year, interest rates could fall, and you may miss out on the return you once had. If you find the high rate appealing, consider locking it in for longer through a bond.
Remember, financial goals should typically be looking towards the long-term: preserving your wealth's value and generating a passive income. Therefore, your investments should reflect this long-term view. Bear in mind, both cash (short-term lending) and bonds (mid to long-term lending) promise fixed returns in hard currency, making them vulnerable to inflation. Unlike these, productive real assets (equities) offer returns in goods and services, the value of which increases with inflation.
Conclusion
In summary, while cash is necessary for daily transactions and emergencies, over-reliance on it or other non-productive assets can undermine long-term wealth preservation and growth. By investing wisely, you can safeguard your wealth against inflation, generate a passive income, and ensure you're well-equipped to meet your future financial goals.
Remember, 'cash is king' doesn't mean hoarding cash. It means having just enough liquidity to manage risks and seize opportunities, while the rest of your assets are busy working for you.
A picture is worth a thousand words. We can learn a lot from history, and we are lucky to have more than a hundred years of data on performance of different types of assets. See below the chart comparing these different assets, where all the values are adjusted for inflation.
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