Although cash plays a strategic role in a diversified portfolio, it is not ideal to invest in cash in isolation. There are longer-term trade-offs to be considered.
Market risk is not the only risk
Pask says that market risk or volatility (which most investors are generally more aware of) usually results in a migration away from riskier assets such as equities to perceived safe-haven investments such as term deposits or money market accounts.
“However, during such times, investors caught up in the panic turn their attention away from other risks that could affect their longer-term returns, such as inflation risk and longevity risk. Inflation risk is the risk that long-term inflation growth will exceed the long-term investment growth of an investor’s portfolio, thereby effectively reducing the purchasing power of their savings.
“Longevity risk is the risk of an investor outliving their savings if their long-term investment growth is insufficient to sustain their future living expenses. Due to medical advances, global average life expectancy now far exceeds 85 years – the age to which investors generally plan their investment horizons. Recent research shows that by 2030, average life expectancy will exceed 100 years – this is already the case in seven countries. In fact, average life expectancy increases by five hours every day.”
To successfully grow wealth over the longer term, investors need consistent exposure to equities to hedge against both inflation and longevity risk.
The good news that most of us will probably live longer than we expect means that we will also have more time to give our investments the required time to grow, Pask adds. Equities can help investors to do this successfully over the longer term. While stock prices might suffer during periods of market volatility, research conducted by our investment division shows that money market accounts usually underperform the FTSE/JSE All Share Index (ALSI) over rolling 10-year periods.
Looking at the 10 years preceding the peak of the financial crisis (31 March 2008), the ALSI returned 19.4%, compared to 11.2% from the money market. More recently, in the 10 years preceding 31 May 2016, the ALSI returned 13.34% and the money market 7.5%.
“Unfortunately, there is a perception that equity is the riskiest investment. However, this depends on an investor’s investment horizon and the type of risk considered. While cash will grow at a steady pace, investing in equities managed by active managers can reduce longevity risk. Investors may therefore well be rewarded with an ‘equity premium’ over cash returns in exchange for the shorter-term certainty they sacrifice. Investors who are cognisant of the bigger picture find comfort in the long-term probabilities that are stacked in their favour,” he says.
Risks inherent in individual cash instruments
Investing in cash instruments might seem more attractive during uncertain times, but comes with its own inherent risks.
“For example, a cash instrument might be exposed to credit risk, especially if the bank issuing the instrument is not scrutinised by rating agencies. The instrument-specific risk is also very high, because the investment is in a single security as opposed to a pool of diversified assets,” Pask concludes.