The Risks and Rewards of Cash

Wealth creation is a very simple formula — buy low and sell high. Sounds easy enough, yet we know there’s a world of difference between theory and practice.

Shares aren’t cheap right now. So to ‘buy low’ requires holding cash in the meantime. That’s a problem in these highly manipulated and uncertain markets.

The prospect of a Cyprus-like bail-in, coupled with the lowest rates in history, has made investors think twice about holding cash. In fact, many investors see cash as a higher risk and lower reward option.

A reader sent me an email after my Markets and Money article last week. He wondered how I could recommend holding cash with all the risks that entails.

My response is the same on I gave Gowdie Family Wealth readers. Every asset class has a benefits versus risk equation — even cash.

The benefits for me in holding cash are:

  • Cash provides me with options. The ability to act on opportunities is critical to ‘buy low, sell high’.

  • Cash provides emotional comfort. At different times in life, my cash reserves have ranged from negligible to plentiful. The latter position makes me sleep so much better at night. There’s a lot to be said for the intangible benefit of personal well-being.

  • Having lived and worked through three significant market downturns (1987, 2000 and 2008/09), I can tell you having cash provides you with clarity of thought.

  • Share investors who are being beaten up badly tend to lose objectivity. On the other hand, cashed up investors are dispassionate spectators and generally remain calm. They are better positioned to make rational investment decisions as opposed to panicked reactions.

In pre-GFC days, the primary risks associated with holding cash were inflation and taxation. Since Cyprus, ‘confiscation’ has been added to the list of risks.

In an inflationary world, cash has diminished buying power. With the world teetering on the brink of deflation, the risk of inflation is not as great as it was in the 1980s and 1990s.

Unfortunately, interest earned on cash is fully taxable, reducing your net return.

Shares pay fully franked dividends and depreciation allowances can be offset against rental property income.

The tax I pay on my cash holdings is the cost of security.

But consider that cash held within a self managed superannuation fund in accumulation phase is only taxed at 15% and in pension phase is tax free.

The next risk is interest rate risk. As we’ve seen in the US, central banks can, at their whim, reduce the rate of return on cash holdings. The Reserve Bank of Australia latest rate cut indicates Australia is following suit.

Expect rates to go lower (much lower) in the coming months. The lowest rates in history are a sure sign all is not well in the world. As perverse as this sounds, my reasoning is the lower cash rates go, the stronger the case is for holding more cash.

One of the great positives for cash compared to other assets was the security of capital.

That was until Cyprus adopted ‘bail in’ provisions for deposits greater than the government guaranteed amount of 100,000 euro.

Since then, depositors around the world have questioned the safety of their money in the bank.

We know the GFC has forced policymakers to make up the rules as they go. Our debt dependent economic model demands ever increasing amounts of credit to prevent the system from collapsing in on itself. When the flawed model finally fails, no one really knows how violent the withdrawal symptoms are going to be.

The reality is no one knows how severe the next downturn is going to be and where the bullets are going to ricochet — especially the ones from the derivatives chamber.

For the purpose of this exercise, let’s assume it is going to be really ugly, far worse than the GFC.

During the GFC, all asset classes except cash fell in value. The global scramble for security created a wholesale exodus to US Treasuries and cash holdings.

A severe downturn is likely to add to existing deflationary pressures. Indebted households will bunker down even tighter, restricting spending to essentials only. Baby boomer retirees with lower portfolio values will rein in their spending. Against this dire scenario all assets should once again come under fairly intensive selling pressure.

Australian banks are heavily exposed to the residential property market. Therefore any significant downturn in housing values and increases in loan defaults could impair the banks’ balance sheets. If confidence in the banking system is lost, there’s the very real prospect of a run on the banks.

The bank run in late 2008 forced the government to guarantee deposits held with Approved Deposit Institutions (ADIs). The government guarantee remains in force for deposits up to the value of $250,000 with each ADI.

Here is the link to the ADIs covered by the deposit guarantee.

Should a bank run see an ADI falter, the government’s Financial Claim Scheme (FCS) would come into force.

The Financial Claim Scheme (FCS) for ADIs entitles deposit holders to receive a sum equal to their deposit balance plus any unpaid interest (up to the maximum guarantee amount of $250,000 per taxable entity). The Australian Prudential Regulation Authority (APRA) aims to make these payments within seven days from the FCS being activated.

Under the Banking Act, the legislation only allows the federal government to initially advance a maximum of $20 billion per ADI. The four major banks have deposit bases that dwarf this amount. In the event one of the major banks fails, the $20 billion would amount to only cents in the dollar of the deposits they hold. In real terms, deposit holders would not receive their $250,000 guaranteed amount.

However, should a greater sum be required to satisfy the guarantee, the Act does leave the door slightly ajar. Parliamentary approval can be sought to advance further sums above the initial advance limit of $20 billion.

Deposit amounts above the $250,000 guarantee cap per taxable entity risk being confiscated (partly or fully) under the proposed bail-in legislation. Again, assuming a worst case scenario, you should expect a complete ‘bail-in’ for amounts above the guarantee limit.

Trying to provide investors with absolute certainty in this area is impossible. We simply do not know how events are going to pan out. Based on that caveat, here’s the logic I’m applying and only time will tell whether it was indeed logical or illogical:

  • Working on the ‘buy low, sell high’ strategy, I have no choice but to hold cash.

  • If alternative asset classes (property, shares and precious metals) suffer significant losses, where else can you hold your cash? Under the bed? In a safe deposit box? If these options don’t appeal, then it leads you back to investing in an approved deposit taking institution.

  • The banking system is the heart of an economy. Without it, the system freezes up. We caught a glimpse of this during the GFC.

  • The government will do everything within its power to maintain confidence in the banking system. If that means printing the money needed (after parliamentary approval) to shore up the ADI guarantees (especially for the major banks) then they will do it. Printing money to do this is no great stretch of the imagination these days.

  • For investors to avoid the angst of waiting for legislative approval to advance more than the $20 billion maximum FCS, it would be prudent to have your cash holdings with smaller ADIs that have lesser deposit bases (under $20 billion) as your preferred institutions of safety.

  • In the belief ‘bail-in’ provisions will be invoked, the maximum you should invest per taxable entity (individual, partnership, corporate and SMSF) is $250,000 per ADI.

  • Australia is NOT Cyprus. We have a AAA credit rating. We have the ability to print our own currency. We have a much lower debt to GDP ratio. In other words, Australia has far more options than Cyprus.

There is no absolute comfort I can give you regarding the safety of cash in the event of an unprecedented market meltdown.

I have genuine concerns about how best to secure our cash holdings. The best option to me is spreading cash around enough ADIs to remain under the $250,000 guarantee limit (per taxable entity) and hoping our politicians act out of self interest in trying to keep social unrest to a minimum by placating all depositors under the guarantee limit.

It’s a plan based on an element of common sense mixed with faith in politicians honouring their promises. Not foolproof, but if anyone knows a better way to keep cash available to take advantage of ‘the sale of the century’, then I’m all ears.

Vern Gowdie,
Editor, Gowdie Family Wealth

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Vern Gowdie has been involved in financial planning since 1986. In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners. His previous firm, Gowdie Financial Planning was recognized in 2004, 2005, 2006 & 2007, by Independent Financial Adviser (IFA) magazine as one of the top five financial planning firms in Australia. He has been writing his 'Big Picture' column for regional newspapers since 2005 and has been a commentator on financial matters for Prime Radio talkback. His contrarian views often place him at odds with the financial planning profession. Vern is is Founder and Chairman of the Gowdie Family Wealth advisory service, a monthly newsletter with a clear aim: to help you build and protect wealth for future generations of your family. He is also editor of The Gowdie Letter, which aims to help you protect and grow your wealth during the great credit contraction. To have Vern’s enlightening market critique and commentary delivered straight to your inbox, take out a free subscription to Markets and Money here. Official websites and financial eletters Vern writes for:

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