Saturday, January 05, 2008

The Problems With Cash

At the height of the dot com boom in the late 1990s, a popular saying was that "cash is trash". While I do not regard cash (including bank deposits, CDs and similar instruments) as being trash, I view cash as a very poor form for holding wealth. My main objections to cash as an asset class are:

1. the returns are unacceptably low. In fact, in real terms they are currently negative. (Inflation in Hong Kong is currently above 3% and you will not get deposit rates much better than this without locking you money up for several years, and then not by much.). For all practical purposes, cash sitting around in a bank account is a depreciating asset;

2. if you have a target rate of return for your assets as a whole, every dollar that is locked into a low return asset class like cash forces you to take greater risks with the balance of the portfolio in order to achieve the overall target return. In my own case, earning a given rate of return (6.7%) on my assets as a whole is necessary in order to retire on schedule. Having a portion of my assets held as bank deposits earning 2% means that I have to take more risks with the rest of my portfolio;

3. temptation to spend. Having meaningful amounts of cash sitting in the bank could easily tempt some people to go on a spending spree. So far I have managed to avoid this, although every time I walk past the art gallaries of Hollywood Road I start thinking about some of the empty spaces on the walls of our home.

Of course, cash does have its good points. The most important is giving you the means to seize opportunities as and when they occur. As appealing as this rationale sounds, I suspect that the number of occasions on which an exciting investment opportunity is missed for want of ready cash would not, in most market conditions, compensate for the opportunity cost of leaving the money sitting in the bank while you waited for that opportunity to present itself. For some people, an emergency fund may be a reason for keeping some money in cash. I view emergency funds as wasteful and, in my own circumstances, unnecessary.

The reason this issue has arisen is that I have not made a significant investment since I completed the purchase of a property in July last year (and the fit out in August - October). In fact the only investments I have made since then have been monthly contributions to some unit trusts and token additions to my position in silver. The cash has been building up and the difficulty in identifying attractive opportunities has become frustrating.


Cheapster Bob said...

A good post my friend but I have to disagree with you about the emergency fund for a couple of reasons.

1. They provide peace of mind for the individual. If your vehicle tanks you will need money on hand to get it repaired. No one wants to call friends or their parents asking for money after all. If you use a credit card it could be more then you can pay by the end of the month subjecting you to high interest costs.

2. One can find savings accounts at banks online for above 5 percent interest at present. This is nothing to sneeze at as it is fairly rigid. By that I mean if the institution lowers the rate to 4 percent you simply close your account and move it to the next one with 5 plus percent.

You have good reason to dislike cash though. Most people are not disciplined enough to leave it be. They will spend it nearly every time with a promise of refunding the account at some unknown date.

traineeinvestor said...

Hi Bob

Thanks for the comments.

In relation to emergency funds, I agree that for most people they give peace of mind and are strongly advisable. I always kept a bit of cash in the bank when I was younger. Today, we do not need an emergency fund as (i) we have two incomes, each of which is enough to meet our monthly outgoings (ii) we have quite a few liquid investments (shares, unit trusts, silver) which could be sold in an emergency and (iii) my income is trailing (effectively I would continue to receive income for 3-5 months after termination should that happen). We do not run a car (unnecessary in HK) and have full medical insurance (and access to a good almost free public health system). It's hard to see how useful an emergency fund would be to us?

2. are the 5% rates available in Hong Kong dollars and for short terms? I know we can get better rates in AU$ and NZ$ but I prefer not to take the currency risk.