As interest rates around the globe have reached decade highs, many investors have fallen into the trap of trading long-term gains for short-term yields.
In the current market, many investors have increased their allocation towards cash investments to achieve yields up and above 5.0% p.a. While this guaranteed return can be seen by many as risk-free, it is important to consider the implications of moving from equities to cash and how it may impact achieving one’s long-term financial objectives.
Historical data has shown that equities have outperformed cash investments by a significant margin in the long run. The two primary reasons for this are the loss of purchasing power from cash over time and the equity risk premium.
The equity risk premium refers to the excess return that is achieved when investing in equities, over and above the risk-free rate. The premium compensates investors for taking on risk when investing in companies.
Much of this risk can be managed by ensuring versatility in your portfolio and through funds where you can adjust the blend to suit your risk profile. You can also use a trusted advisor to help guide your investments.
It should be noted that whilst equities carry a higher risk as opposed to cash, it’s important to realise that cash is not a risk-free asset in the long term, because of the time value of money. The time value of money is experienced through the loss of purchasing power, as inflation rises. Over very short periods of time in history cash returns can outpace inflation, however, over longer time horizons, inflation erodes the value of cash faster than equities.
Based on past performance over the last 20 years cash has returned 90.0%, whereas equities have returned 400.9%. However, in that same time, the price of goods and services has increased by 54.0%. Looking at the short term, in November the ASX 200 returned 4.1%, the average cash rate was 5.0% and the increase in the price of goods and services was 4.3%. This shows how cash can outperform equities in the short run, however, it loses traction over time as equity returns compound.
Cash is and will always be an integral part of any portfolio, not only for liquidity but for income and diversification purposes as well. However, one should be careful if they decide to materially change the asset allocation of their portfolio to take advantage of current high interest rates. It is important to consider the time horizon of your financial goals and plan accordingly. Choosing when to return this cash back to equities is another risk in itself, as timing the market is very difficult. Empirical evidence has proven time in the market prevails over timing the market, given an investor’s time horizon is sufficiently long enough to ride out any short-term volatility.
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