During periods of economic uncertainty, many investors tend to transfer their capital into cash investments. This is especially true for retired individuals who are living off of a capital lump sum. Such retired folk may adopt this (what they consider to be) conservative approach and may have a high allocation of their capital to cash and a very small allocation, if any, in equities and property. This high cash allocation is chosen as investors believe that cash is a risk free investment and that their capital will have less risk in a money market fund than in a fund with exposure to equities and property.
Many investors base their decision to invest in cash on a misunderstanding of the following definitions: risk and volatility. If investors had a better understanding of risk and volatility, it may encourage them to adjust the asset allocation of their portfolio.
Changes in share price
Volatility is the measure of the change in share price over a given period of time. If the price of a share increases or decreases rapidly over a short period of time, the share would be considered to be highly volatile. If the price of a share almost never changes, or increases or decreases gradually, the share would be considered to have low volatility.
Risk is the quantifiable likelihood of loss or less-than-expected returns. There is a significant chance that an equity fund may have a negative return over a time period of 1 year due to the high volatility associated with equities. However, over a period of 20 years, there should be little risk of this same equity fund having a negative return. It is imperative that investors understand the correct definitions in order to make sound investment decisions.
Ronald Reagon once said that inflation is as violent as a mugger, as scary as an armed robber and as deadly as a hitman. The danger with investing in cash is that cash has historically not achieved returns in excess of inflation.
Inflation has averaged 7,6% per annum between 1990 and 2010 whereas the average cash return (money invested in the bank with fixed deposits etc) averaged 6,8% per annum during the same period. We can therefore state that there is an illusion of safety in less volatile investments (such as cash). A conservative investor who insists on investing his or her money in the bank as it is a “risk free” investment, is guaranteed not to beat inflation over time. There is a momentous risk in holding large cash investments for the long term.
Diversity is key
It is vital that our investments are diversified (that they are split between different asset classes such as cash, bonds, property and shares) and are invested with an overall strategy to beat inflation. How our investments are divided between cash, bonds, property and shares will be dependent on the targeted return and the time horizon for your investments, which is ultimately based on your lifestyle needs, goals and objectives. Achieving returns in excess of inflation over the long term is a key factor investors need to consider in their decision making.