The essence of investing lies in consciously taking risks. It may sound like well-thought-out wisdom, but it offers little practical guidance. Investors must first ask themselves whether they want to take any risks with their wealth at all. Nowadays, safe investments in money markets actually yield a decent return compared to the past ~15 years (around 3.5-4% in EUR and 5.5% in USD). Moreover, one would generally sleep more soundly when their money isn’t invested in more risky assets like stocks. At the same time, a classically trained economist would argue, “there is no such thing as a free lunch.” In other words, what are investors giving up by investing in cash and having a peaceful night’s sleep? Spoiler alert – quite a lot!
- The benefits of volatility
Firstly, the yield on cash investments today is a poor predictor of future returns. While the value of a cash investment is stable, the current interest rate is not. However, for long-term investors the stability of their wealth in the short term is less relevant than how future returns will respond to interim volatility. These investors rely on investments to generate future returns.
To illustrate – when the price of a bond falls, the yield increases, thereby keeping the return of the bond stable. A similar logic applies to stocks, although the relationship is noisier. This means that investments are less risky for long-term investors than the short-term volatility might suggest. Back to cash: because its value is stable, you do not benefit from a stabilization in future returns. For example, if interest rates drop from 5% to 3%, you will not be compensated with an increase in the value of your savings account. In short, investors who were counting on a fixed annual gain are confronted with a potential shortfall.
- Compensation for risk
A second argument against investing in cash is that the absence of risk leads to a lower expected return. For instance, stocks require a risk premium as their short-term value can fluctuate significantly. In other words, the future return on stocks needs to increase with rising interest rates. Historically (since 1900), this relationship holds up well. As demonstrated in the figure below, higher interest rates are associated with higher returns on both stocks and bonds. This suggests a persistent risk premium exists in addition to cash returns.
While the current yields of 4-5% may seem attractive, investors are still forgoing potential risk premiums by holding onto cash. The consistently lower expected returns have significant long-term implications. Nevertheless, research indicates that higher interest rates often result in reduced exposure to riskier (long-term) investments.
- Erosion due to inflation
The combination of the two aforementioned factors makes cash an unsuitable investment instrument for long-term investors, especially when adjusted for the impact of inflation. While the nominal value of cash remains stable, there is a significant chance that its real value, measured in purchasing power, will erode. The figure below illustrates the probability of a loss in purchasing power for various investment instruments and investment periods (1, 10, and 30 years). It confirms that cash is a risky long-term investment with a substantial chance (~38%) of a decrease in purchasing power. On the other hand, stocks appear to be a more suitable instrument for keeping up with inflation over the long term (~4% chance over 30 years).
Extra costs of pessimism
The ‘rational’ solution for long-term investors may seem simple: incorporate more risky investments. However, this is easier said than done due to behavioral challenges. In particular, (excessive) pessimism entices investors to take on less risk than would be desirable in the long term from a rational perspective. They tend to overestimate the likelihood of an imminent market crash, causing them to delay their investments.
“Far more money has been lost by investors preparing or anticipating for corrections, than has been lost in corrections themselves” – Peter Lynch
Moreover, investors often extrapolate recent events to form their future expectations. As described, the future expected return of an investment rises after a recent price decline, even though investors expect a lower return. This means they become more pessimistic about investing during good times.
Finally, the media plays a significant role in investors’ pessimism. News appears to have an asymmetric effect on expectations. Articles with a negative sentiment increase pessimism, but positive articles typically have no effect. Paradoxically, by the time the media reports on something, it is already reflected in the prices. In other words, the content does not contain new information about market expectations.
Bluemetric Insight | Recently, investors have been considering holding more cash due to rising interest rates and the sense of security it provides. Unfortunately, these short-term choices negatively affect long-term outcomes. Establishing a long-term strategic plan can mitigate this risk. However, cash can still play a role in some strategic plans for (i) withdrawals, (ii) a liquid buffer, and (iii) for financing illiquid investments. Investors should weigh the trade-off between short-term certainty and the negative long-term effects of investing in cash.
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