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On the Horizon
Your monthly entertainment and thought-provokingness from the world of personal finance

What is....?
Part 1 - Cold, hard cash.

 

August 2016
Russell Robertson, CFP
® 

As the calendar turns over to August and kids and parents alike start gearing up for “back to school” mode, we thought we’d join in the fun and present a two-part “What is…?” series. This week we’re going to look at cash money, next week will be securities (stocks and bonds).  What exactly are these things?  Why do you want them, and what does it mean to invest in them?

We decided to start with cash because, believe it or not, it is the most controversial of the three.  It’s fairly unanimous that one should hold stocks and bonds in a diversified portfolio, with some semantic arguments over the specific percentage allocated to each.  But what about cash?  

Most advisors you ask will probably say that no, cash is not an asset class.  They’ll talk about “cash drag” on a portfolio (the idea that money not invested is missing out on returns, so the overall portfolio underperforms the market), the inability to keep up with inflation (the concept of inflation and how it is measured deserves its own newsletter someday, but broadly speaking the idea that your $100 will buy you less in the future than it will today), and the fact that cash doesn’t yield anything (no dividends, statistically zero interest in the current low rate environment).  They’ll talk about better options to protect your portfolio if you’re afraid of it losing value - long/short strategies, absolute return funds, managed volatility, options strategies, non-correlated diversification blah blah blah.  (As an aside, there’s possibly also a self-serving aspect to it that usually won’t get mentioned - how do you justify charging management fees on cash?  Why wouldn’t a client just keep it in the bank or under the mattress for that matter?  It’s basically the same thing.  In fact, some firms don’t let their advisors charge a management fee on cash.  So...incentive much to keep your money invested?)

We like cash as its own asset class within portfolios.  Sometimes a little bit.  Sometimes a lot bit.  But before we get into that, take the red pill for a second and follow us down the rabbit hole of...What is money?



What is Money? 

Think of money as a societal concept of a store of value.  Go back in your mind.  Way back.  Are you seeing dinosaurs?  Okay, come forward in time a bit, you're too far back.  Let's imagine there's no such thing as money.  Goods and services are exchanged via the barter system.  You have something we want (a couple potatoes), we have something you want (a nice cave-aged cheese), we come to terms on an exchange we're both happy with, and voilà!  The objects exchanged each have a set value to the recipient, but neither is considered money because it doesn't have a constant value across society.  You can't necessarily take the cheese you got from us and give it to someone else as payment for a new quiver of arrows. 

Now imagine there was something considered valuable by everyone in society.  It could be gold, sure, but could also be any number of other things: spices (pepper, saffron, nutmeg...think Europe, even pre-Silk Road), wampum (among the early colonists), massive, immovable rai stones (among certain Micronesian cultures).  As long as it is considered valuable by society as a whole, it functions as money.

(Inflation tangentially enters into this discussion at this point because something’s value is often inversely proportional to its availability.  Why isn’t pepper still used as money?  Because it’s everywhere.  It is the cheapest of the spices in your grocery store.  For interesting reading on the subject though, do look into what happened when the Chinese treasure fleets during the Ming dynasty brought back literal boatloads of pepper to China.)

Evolution of Money in a Nutshell

A lot of the unique examples of early “money” worked because they were so localized.  Would anybody in Europe accept payment in rai stones?  Probably not.  What is recognized as valuable globally, however, are certain precious metals.  Such as gold.  So imagine a modern-ish society where money is gold and silver coins.

Let’s say that certain institutions - banks and governments - started writing IOU's instead of paying people in coins.  Here’s a piece of paper: a promise to get paid a certain amount of coins at some point in the future.  And because it was issued by, say, a bank that everybody knew had a vault full of said gold coins to back up the IOU piece of paper, it was accepted by society as a standard store of value.  The gold standard, some might even call it.  And all of a sudden instead of gold coins changing hands, these IOU’s, these pieces of paper, are being exchanged throughout society for goods and services.  Let's call these pieces of paper "bills".  See where we're going here?

Now let’s imagine there’s someone - we’ll call him “Richard Nixon” - who comes along and says, nah, you know what?  This note isn’t redeemable for gold.  It just is.  That newspaper that you get for a one dollar bill?  Great, you can still use that one dollar bill to buy that newspaper.  You just can’t turn it in to a bank for one dollar’s worth of gold.  

And that is how you get the birth of fiat money - money backed by...essentially nothing.  Just a history of societal convention and a belief in the trustworthiness of the issuing government.  What we refer to today as “cash”.  But if it’s just a piece of paper, can’t you print as much of it as you want?  Why yes, yes you can.  When it's not backed by anything, the value of money is essentially controlled by supply and demand.  And then you can get the same sort of inflation issues that China saw with peppercorns back in the 1400's.  Taken to an extreme, you get “hyperinflation” - Germany after World War I, Zimbabwe currently, and Venezuela in the next two years.  This is what hyperinflation looks like:

   

It's not pretty.

Enter Money Creation

How has most money in today’s economy been created?  Printed by the government, you say?  Yes, you’re right!  Wait, what’s that Steve Harvey?  Oh sorry, nope, you’re wrong.  It is debt.  Money is created through debt.

Here’s how a bank works in theory: You put your $1,000 in a bank in exchange for 1% interest (we wish!).  The bank then takes that $1,000 and loans it to somebody who wants to buy an espresso machine to start a coffee shop and charges her 5% interest on the loan.  The bank makes money on the loan.  You make money essentially by giving the bank the privilege of using your money.  

Now, in practice, the bank is required to keep a little bit of “reserves”, in case the coffee shop doesn’t work out and the loan doesn’t get repaid.  So you have $1,000, which you use to buy things and pay your bills, and Ms. Coffee Shop has, say, $900, which she uses to buy things and pay her bills.  *Poof*! $900 created.  Rinse and repeat.  Currently, banks do this roughly four times, on average.  There is $3.8 trillion or so of actual physical currency (cash) in circulation, and roughly $12.8 trillion dollars in our financial system.  

Now, if you actually went to the bank and wanted to get your physical $1,000 dollars back in the above scenario...well.  That’s what’s called a run on the banks.  It’s not that they don’t have it...they just don’t have all of it right that second.  Remember It’s a Wonderful Life?  Or Greece a couple years ago?  When there were limits on how much people could withdraw in any given day?  Yeah, not pleasant.

    

(Take another red pill and spend some time looking up “Shadow Banking” - think of all the non-banks who want to give you money.  Say you go to Macy’s.  And instead of using your debit card or existing credit card to buy that perfect late-summer cocktail party outfit, you fill out the form and get a Macy’s card because, well, 10% off your first purchase and 0% APR for 12 months.  Poof!  Money creation.  By Macy’s!)

Financial Alchemy

Take a deep breath and stay with us, we’re almost full circle here.  Since the financial crisis, we’ve seen three things happen with respect to money.  1) Banks aren’t lending nearly as much anymore (because of concern over stricter regulation and lack of demand); 2) Interest rates on cash have gone down to basically still zero (and are in fact negative in much of the world); 3) The Fed has created an additional $1.5 trillion or so in additional money.  (But wait! you might say, isn’t that the opposite of how you just said money is supposed to be created?  Why yes.  Yes it is.  Emphasis on supposed to.)  Now, it is our contention that most of that money has ended up in the financial markets, driving asset prices higher across the board.

Why would that be?  Because it's uncomfortable to hold cash.  It's uncomfortable to watch your portfolio underperform the market and feel like you're missing out (there's that "cash drag" thing).  It's uncomfortable to see the prices you pay for groceries, gas, and school supplies go up every year while your cash in the bank stays at the same level...or goes up by maybe thirty cents a year.  So you buy stocks.  But whoever sold those stocks to you is now holding that cash!  And they start to feel uncomfortable.  So they buy stocks again and pass the hot potato on to someone else.  

Remember how we said the value of cash is largely dependent upon supply and demand dynamics?  Controlling those dynamics has a fancy name: "monetary policy", and it's carried out by a country's central bank (the Fed, here in the States).  Now, here is the last 7 years of monetary policy in two words: Wealth Effect.  The idea that if people see their portfolios increasing in value, they will feel wealthier and thus more inclined to spend money thus in turn stimulating the economy.

Here are another two words: financial alchemy.  The problem with the wealth effect is that, much like actual alchemy, it’s not real.  Unless your name is Edward Elric.  If your portfolio is fully invested and grows to one million dollars, that’s great, but that’s not actually a real one million dollars unless you sell and realize that gain.  If you wake up one morning and the market is down 10%, well, so much for having a million dollars.

Final Thoughts

(Inhale. Exhale. Om.)  Welcome back.  Quite the ride, wasn’t it?  Here’s what this all means practically, for you, today:

We feel that cash is the only way to reliably protect portfolio values in the short-term.  In the long-term yes, it won’t keep up with inflation, and no, it probably won’t get your portfolio to where you want it to be in order to retire comfortably.  But in the short-term, given our views on market valuations?  We’ll say it again: the biggest risk in investing is not that you’ll lose everything (assuming you have a diversified portfolio); it’s that you’ll be forced to sell when prices are down.  This is the opposite of realizing that one million dollar portfolio.  It’s realizing, say, six hundred thousand dollars and more importantly, giving up the opportunity to grow that back to one million.  

The point of going to cash within a portfolio is two-fold: 1) protect the value of that part of the portfolio in the short-term and 2) be able to take advantage of future opportunities that may present themselves.

Feel free to ask us how this works in practice, if it sounds like something that might make you feel more comfortable sleeping at night.

We often get asked about how much cash one should hold, or how much cash is too much and should one instead be investing the money.  We recommend that setting aside 6 months’ worth of expenses as a cash “emergency fund” in a savings account should be a top priority, before worrying about investing (outside of a retirement account).  Given the current market environment, we also recommend that any planned expenses that will come out of your current savings/investments in the next 2-3 years (buying a new car? Putting a down payment on a house? A wedding?  School tuition?) be held as cash as well.  If you have $100,000 in an investment account and are going to spend $30,000 on buying a car next year, go ahead and just hold that as cash right now.  What we’re trying to avoid here is a situation where your portfolio drops to $85,000 and then you have to sell an additional $30,000 to pay for the car.

We also recommend shopping around for your various online banking options.  Interest rates are close to zero, and you are probably getting nothing on your checking and savings accounts if you have an account with any of the traditional banks.  However, there are online banks (we’ll refrain from naming any specific ones, but just Google “best online only bank” for a pretty comprehensive list) as well as credit unions that are paying pretty close to 1% on FDIC-insured accounts.

It may not be backed by anything these days, but cash is still king.

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