By Max Osbon
Whether you intend it or not, holding cash is a direct investment decision. And just like real estate, gold, fixed income, and equity markets, cash is an investment that provides compensation for the associated risks. How are you being compensated for risking your money in a cash investment?
It may seem like the compensation for holding cash is zero – put a $100 bill in a jar for a rainy day in 2011 and when you take it out in 2013, it is still a $100 bill.
But it will be worth less.
A lot less. Over the last 15 years the annual return on cash, shown on the above graph, is a loss of 2.5 percent per year – consider it rent for one of the world’s most stable and ubiquitous assets. The graph is based on the Consumer Price Index. CPI, published monthly by the Bureau of Labor Statistics, tracks the cost of a one-size-fits-all basket of goods from groceries and apparel, to transportation and education.
Given that modern inflation peaked in 1983 at 13.5 percent, the CPI at 2.5 percent looks pretty favorable. But if you held a million dollars in cash from 2005 to 2008, it cost you $127,000 in purchasing power. That’s like making a non-deductible donation to the Loch Ness Monster – the money’s gone forever with nothing to show for it.
If this rate continues, expect to lose half of your purchasing power every 28 years. Raise the inflation rate to the longer-term average of 3 percent and your purchasing “half-life” shrinks to 24 years. And as we discussed a few weeks ago, Zimbabwe’s runaway prices rose so quickly there that the9 half-life of purchasing power would have been measured in days or even hours. (See “Have you ever seen a $100 trillion dollar bill?“)
Control what you can
You can’t decide what inflation will be for the year 2013 – so far it’s 1.1 percent – but you can decide how you will let it affect your portfolio strategy. What are the alternatives to cash?
To overcome the persistent erosion of inflation, you’ll need to assume some risk beyond the risk of inflation. ETFs provide highly liquid access to a wide range of asset classes. For example:
- TIPS: Treasury Inflation Securities have a principal value that is marked up to reflect the erosion of inflation and include a minimal short-term interest rate return component. ETFs like Vanguard’s VTIP are very liquid and accessible.
- Fixed Income Markets: Fixed income ETFs do not benefit from inflation, but they do give you a better shot at beating the inflation drain by giving you a rate of return, albeit a modest one. Investing in treasuries for example, with the 10-year rate currently at 2.6%, may stop the bleeding at the very least.
- Diversified Portfolio: While switching from cash to TIPS or bond ETFs may mitigate your annual loss in purchasing power, we suggest an investment approach that takes a much broader view. We encourage investors to diversify across a wide range of asset classes with a goal that is based on achieving long-term goals, not just trying to stay ahead of the CPI. For most investors that means a mix of ETFs – funds that track indexes of stocks, bonds, real estate, gold, and other asset classes.
What do you think about this? Email us or comment below.
Max Osbon – firstname.lastname@example.org
John Osbon – email@example.com
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Inflation rates vary over time and cannot be reliably predicted.