The End Of A Reign – Cash Is No Longer King

Cash is failing to provide capital preservation as it does not maintain its value in real terms. However, a portfolio should have an allocation of cash to provide liquidity.

Cash is failing to provide capital preservation as it does not maintain its value in real terms. However, a portfolio should have an allocation of cash to provide liquidity.

 

In the aftermath of the Global Financial Crisis, Australia and many other economies in the developed world reduced their interest rates to record lows. This aimed to stimulate growth and allow economies to recover from the crisis. This trend has continued in most countries including Australia, where a rate hike seems unlikely in the short to medium term. This has severely impacted the return of cash investments making them mostly negative in real terms.

 

When evaluating the actual performance of an investment, it is important to take into account external factors such as inflation and tax. For an investment to break even it must return an amount equal to inflation after tax; any lesser amount than this would mean negative performance of the investment in real terms.

 

Consider Patricia, she has an at call cash investment returning 1.5% per annum. Long term inflation in Australia is approximately 2.5%. Analysing different scenarios for Patricia from being a retiree to a high income earner, the real return of her investment is:

 

 

Tax (No Medicare Levy) 0% 15% 19% 32.50% 37% 45%
Inflation 2.5% 2.5% 2.5% 2.5% 2.5% 2.5%
Return 1.5% 1.5% 1.5% 1.5% 1.5% 1.5%
After tax return 1.5% 1.3% 1.2% 1.0% 0.9% 0.8%
Real return -1.00% -1.23% -1.29% -1.49% -1.56% -1.68%

 

At first sight, the after-tax returns appear positive, giving a false sense of growth to the portfolio. However, once inflation is considered it is clear that the investments in cash are acting in detriment of the investment portfolio, by continuously reducing its purchasing power.

 

An allocation to cash is appropriate for most investment portfolios. There is no formula to define the amount of cash a portfolio should have, this depends on each investor’s circumstances and risk appetite. A conversation with your financial adviser should allow you to define your investment objectives and outline an appropriate investment portfolio.