In Thursday’s post, I recommended slowly prepaying your mortgage as one way to put your money to work effectively. I also mentioned that people tend to underestimate the value of cash. Today, I want to delve into that a bit more, by comparing how sitting on cash stacks up with investing in bonds or stocks in the current environment.
Cash vs. bonds
Let’s start with the 10-year Treasury bond as an example. Right now, it’s yielding around 2.5 percent. With inflation approaching 2 percent, you get a real yield after inflation of about $5 per year for a $1,000 bond. In 10 years, you get your money back. If interest rates go up by 1 percent, to 3.5 percent, you lose about 8.5 percent of your money—or about 3.5 years of interest. If interest rates go up by 2 percent, to 4.5 percent, you lose about 16 percent—or more than 6 years of coupon payments.
Here’s another way to look at it: You’re effectively betting $1,000 that rates will stay about the same, and you’re taking that bet for $5 per year in real return. You can run these numbers different ways, of course. The point is that interest rate risk can destroy much of your potential return if you don’t hold the bond to maturity.
Now let’s look at cash. If you sit on your money for one year, you’ve given up 2.5 percent in return—but if rates rise, you can buy a bond at the higher rate. If it’s 3.5 percent, you have an extra 10 percent over the 10-year life of the bond, less the 2.5 percent you gave up by sitting in cash for a year, for a net gain of 7.5 percent over that period. Higher rates give a higher gain.
What about stocks?
The same argument applies to stocks, but both the opportunity cost and the potential future returns are harder to quantify.
Obviously, sitting in cash from the start of 2013 to the end was painful; you missed out on a 30-percent return. We know, however, that higher market valuations are correlated with lower subsequent returns over several years. This has often been “disproved”—think 1999, 2006, and other times—but it’s always swung back to be true.
Maybe this time is different. If not, though, the optionality inherent in cash has its uses, especially when stock valuations are high—like right now.
A smart way to buy into stocks and bonds
With either stocks or bonds, it’s almost impossible to perfectly time the decision to buy in with cash. What is possible is to use a disciplined investment process known as dollar cost averaging, where you buy the same dollar amount every month.
Say you’re investing $100 per month. With shares at $20, you buy 5 of them, but with shares at $10 you buy 10. The effect, over time, is that you buy more shares when they’re cheaper and fewer when they’re expensive, which can help your overall returns. You also participate in a rising market—and are both less exposed to and better positioned to take advantage of any declines.
Make no mistake, cash is not an end in itself. Over time, you will lose to inflation, possibly in a much worse way than with stocks or bonds. For investors, though, cash shouldn’t be a four-letter word, but a tool to be used as carefully, and thoughtfully, as any other asset class.
Throwing away a useful tool is kind of silly, and believing you “can’t sit in cash” is doing just that.