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Why Cash is a Poor Investment

February 28th, 2010 No comments

In these turbulent financial times, cash has become a safe haven. However, over the long term cash is not a good investment.

What is Cash?

When we think of cash, we normally think of the physical currency (bills and coins) that we use daily. From the U.S. Government point of view, a more accurate term to use is not cash but money supply. Only a fraction of the money supply is represented by physical currency. Just think of your house: when you bought it or sold it there wasn’t a barrel full of cash exchanged, it was represented by blips on a computer screen account or on a paper contract. The money supply represents the sum of all the money in circulation as well as the money represented as deposits in banks and credit unions.

It’s Not Absolute

One of the first things that I learned about cash when I started investing is that cash is not an absolute measure of anything. We tend to think of cash as a steady barometer that tells us the relative valuation of things. For example, if you search for furniture at multiple stores one of the ways to determine the relative valuation is to compare the cost in dollars; the dollar is used as one means to compare value.

Over the short term cash is a good method of valuing things. Over the long term, the value of currency and money supply are constantly changing making valuation harder to predict.

In financial markets, the value of cash (or the dollar) is itself subject to relative valuation by other things, most notably other currencies. If you travel overseas, you have probably seen that the cost of goods and services is impacted by the conversion rate of dollars to other currencies.

Also, within the U.S., the Federal Reserve manipulates the money supply periodically based upon economic policy goals. Right now, the Federal Reserve is increasing the money supply to spur economic growth since this will lower the cost of borrowing by banks. Over time, the money supply generally increases faster than economic growth causing inflation. This reduces the buying power of your cash.

How Cash Makes Money

If you deposit money at a bank, you earn interest. The way that the bank or credit union earns money on your deposits in money market funds is by lending your deposits out to credit worthy businesses for short terms, typically less than one year. This type of credit is very safe relative to other types of lending since loans made out for short term periods to credit worthy borrowers rarely default.

Since the money supply is not tied to anything, the interest rate is largely determined by Federal Reserve policy and not any real economic asset. So, if you look at the interest you could earn on money market funds over the last 10 years, it would have looked something like this:

  • 2000: 6.2%
  • 2002: 1.7%
  • 2006: 5.0%
  • 2008: 3.0%
  • 2009: 2.5%

If you needed that interest to pay your bills, this would turn out to be a poor investment since the rate of return is unpredictable.

The Perfect Absolute Asset

If cash is devalued over time due to inflation, is there a better place to put it that is safe and has the intrinsic value of a real asset?

Before currency existed people used hard assets such as gold and silver as cash. Even today, you will see some financial analysts recommend that you keep some portion of your portfolio in gold or silver. Because gold is a ‘real’ tangible asset that you can touch, it is uncomplicated compared to other assets like stocks and bonds and always has intrinsic value unlike the currencies of many nations of the past. But even gold is not perfect since its price changes due to supply/demand by commercial and consumer use. Also, like anything else that can be traded easily in a marketplace is can be overbought and oversold due to speculation just like other assets.

Another option is to put your cash in special U.S. Treasury bonds called TIPS which provide protection against inflation. You may not earn much on these but at least you can be assured that inflation won’t devalue your cash.