Blogs | October 9, 2012

Is it a good time to hold cash?

There is an old phrase: “You’ve got to speculate to accumulate.” With savings deposits paying pitiful interest rates, this old line seems more apt than ever. But it shouldn’t be. It might even be positively dangerous.

Cash and the environment
A moment’s thought will tell us why. Interest rates are low because central bankers are desperately trying to support moribund economies, and to save them from the risk of disaster, such as if the US economy falls off its fiscal cliff or if prolonged fiscal austerity in the euro causes deep recession or a break-up of the single currency.
But this, of course, is an environment in which returns on shares are likely to be poor and in which there’s a big risk of them falling a lot. It also means there is a chance of us losing our jobs and not being able to quickly find a decent new one.

Cash as protector
In this context, cash is really useful. It offers protection against both equity loss and job loss. The same things that cause interest rates to be low, therefore, also make it worth holding cash. Yes, the price of protection against a bad economy is high – in terms of foregone returns. But this is because demand for such protection is high, and a high demand means a high price.

Cash and the outlook
Of course, it could be that central banks are too pessimistic and stock markets will soar as risks recede and the economy recovers. Whether this happens or not is debateable. But one thing is clear – the fact that interest rates are low is largely irrelevant to the debate of whether it is a good time to hold cash.
However, even if things do return to normal, there’s still a good case for having cash savings. This is because even in normal times, there’s a high chance of shares doing badly.

Cash and the alternatives
Figures from Credit Suisse show that, since 1900 the average return on global equities has been 5.4% a year after inflation. That compares to 0.9% on cash. But cash has an advantage over equities – it is safe whereas shares are not. Credit Suisse figures show that the annual standard deviation of equity returns since 1900 has been 17.7 percentage points. This means that in any one 12 month period, there’s a 40% chance that shares will do worse than cash. And even over a five-year period, there’s a roughly one-in-five chance they’ll under-perform.
Cash protects us from this risk.
These historic numbers probably understate the benefits of cash. This is because the 20th century was a very lucky period for stock markets because, on average, many of the things investors worried about – depression, revolution – did not occur, and so shares benefited from relief rallies. Economic theory – in the form of the equity premium puzzle – tells us that shares should out-perform cash only slightly. Which again increases the case for the latter.

Cash and inflation
You might object that cash savings would suffer if inflation rises. Not necessarily. For one thing, if this happens, central bankers could raise interest rates. And for another, inflation is often bad for shares too; stock markets slumped in the inflationary 1970s and surged in the disinflationary ‘80s.

Cash…and health
There’s another big reason to hold cash. It stops us getting into debt. This is useful not just because borrowing costs are high, but because debt is associated with increased stress.  In this sense, cash savings are good for your health.
In saying all this, I’m not just making a case for having big bank deposits. I’m also explaining something. Central bankers had hoped that slashing interest rates would help revive economies. Such hopes have been disappointed. One reason for this is that low interest rates do not greatly encourage people to reduce their cash holdings and spend more. And nor should they do so.


Chris Dillow
Chris Dillow

Investors Chronicle writer and economist