Three reasons why cash is king

To most investors, cash isn't an asset class like stocks or bonds, it's a means of exchange. That's not a surprising way to think, but it is mistaken. Even if returns on cash are low, it still makes sense to hold at least some. Tim Bennett outlines three very good reasons why.

Is cash an investment? Many investors might say no it's just a means of exchange. But they're wrong, says Socit Gnrale's Dylan Grice. "As an asset class, cash doesn't get the attention it deserves." Perhaps this is no surprise. Textbook investing is all about accepting risk to achieve a decent return who wants to invest in a dead asset that offers a zero expected real return (taking inflation into account)? But right now there are three good reasons to hold at least some cash.

1. Valuation risk

Valuation risk, says James Montier of US fund group GMO, is "the risk that is involved in buying overvalued assets". A value investor knows that when assets get pricey, they should sell because high asset valuations compress forecast real returns. The more expensive something is when you buy it, the worse your future return is likely to be. And here's the rub using data drawn from looking at the S&P 500 since 1940, GMO expects the US index to return 0% a year in real (inflation-adjusted) annual returns, if an investor puts their money in at this level. Indeed, says Montier, once expected returns are at or below zero, "investors risk seeing their investment halve over the next three years".

So while cash returns may be low (savers looking at instant-access accounts in Britain will struggle to earn much more than about 3% gross), the valuation risk pales compared to many other asset classes that don't offer a decent enough reward for the investment risk you have to take. So, concludes Montier, it's "better to hold cash and deal with the limited real erosion of capital caused by inflation, rather than hold overvalued assets and run the risk of permanent impairment of capital".

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2. Fundamental risk

As Grice notes, "the reason many investors won't hold a lot of cash is they don't trust central banks to play fair" with its value (by employing money printing or quantitative easing' combined with record low interest rates). But, over time, nominal (non-inflation-adjusted) interest rates "have generally tracked the rate of inflation". This effectively compensates an investor holding cash for any "ongoing debasement". For example, in the 1970s, when inflation was rampant due in large part to soaring oil prices, "the real total return to cash was actually on a par with bonds and equities". On a risk-adjusted basis (taking volatility into account), cash "was much better than either" because its price is more stable. So investors hunting for a safe haven from inflation could do a lot worse than cash.

If we don't get inflation, it doesn't matter. As Montier notes, "cash is also a pretty good deflation hedge". In Japan (which has flirted with deflation for two decades), from 1990 to 2011 "cash maintained its purchasing power in real terms". Equities didn't come close. Bonds were the best bet, but to have known that then would have required "foresight regarding the path of Japanese inflation". Given no one had that, cash would have been a good way to hedge your bets.

3. Optionality

The third benefit of cash is flexibility. It's liquid and relatively price-stable, giving it "hidden optionality", says Grice. Montier calls this the "dry-powder value of cash". In their desperation to deploy capital, many investors miss the fact that tomorrow's investing opportunities may be better than today's. So waiting for risky assets to get cheaper can pay off. As Grice puts it: "If US equity investors at today's valuations are faced with a long-term return which is not dissimilar to that on offer to holders of cash, why wouldn't they just hold cash?"

Just how risky are Pibs'?

Holders of permanent interest-bearing shares (Pibs) have had some nasty wake-up calls recently. First, the Bank of Ireland threatened (though it is now reviewing the plan) to pay just 20% of face value to holders of the Bristol & West 13.375% Pib (it has owned the building society since 1997). Then Principality Building Society said it won't be redeeming (buying back) its 5.375% 2016 Pibs this year, as many had expected. Instead, until 2016, it will pay a rate slightly above the London Interbank Offered Rate (Libor). That currently works out at under 2%. The message for investors? Look before you leap.

For the uninitiated, Pibs are a way for building societies to raise cash. They were originally shares, but as many societies turned into banks, they became junior' or subordinated' bonds. Like a bond they pay fixed annual interest and most carry a fixed redemption date when the issuer promises to buy back the Pib at face, or nominal', value. So what are the risks? If an issuer goes bust (rare, but it happens), Pibs holders rank behind all other lenders, depositors and building society members holding share accounts. Interest is also non-cumulative, so if a coupon is missed one year it may never be recouped.

The other risk is liquidity: Pibs are thinly traded, so bid-to-offer spreads can be wide. Also be alert to special clauses (options) that allow the issuer to avoid redeeming the Pib at its advertised earliest redemption date as this can affect the interest income you then earn. So if you are tempted to buy a yield of 7%-9% from the likes of Manchester, Coventry or Skipton building societies, be sure to understand what you're getting (watch for Principality-style call options that make the redemption date unpredictable). Remember: no issuer is risk-free.

This article was originally published in MoneyWeek magazine issue number 545 on 8 July 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.