Cash is the highest-risk investment
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RANDS AND SENSE:
By Hannes Viljoen
To call cash the highest-risk investment, you must be clear on the clothes you put on the emperor. What is risk?
Is volatility in investments a risk? Not necessarily. In a relationship, perhaps. As a volatile relationship has a high probability of ceasing to exist and the objective of a relationship is to exist, a volatile relationship is risky. But not necessarily in investments.
Volatility in an investment earmarked for the long term should play little role in the investment decision-making process. Suppose you invest R100 000 today, and in 25 years’ time your investment is worth just over R1 million. It will have grown at an average compounded rate of about 10% a year for the period. Does it matter what happened in-between? For the investment outcome, not much. For possible emotional reactions during the term, arguably.
Is volatility in short-term savings a risk? Yes, if the objective is to have funds available at a given, unforeseen time for an unforeseen event. Suppose you keep the same R100 000 aside for a rainy day. If on the day it rains you only have R75 000 available, it matters. It is a bad outcome. Volatility in short-term savings matters.
Is the permanent loss of capital a risk? This depends on the definition of loss of capital. If your objective is only to preserve capital, not its purchasing power, you can simply put your money in one of the big banks or a money market account and it will likely still be there 20 years from now. It won’t have grown much, but it will still be there, with a bit of interest.
It’s the outcome that matters
Risk, for me, is the possibility of a bad outcome. The possibility of not reaching your objective. Hence, if your objective is to reach a goal, retirement for example, as it is a goal most people ought to invest for, not being able to continue with your current standard of living is a bad outcome.
If your objective is to have enough money to send your child to Oxford, the bad outcome, the risk, is not having enough money to afford doing that. (Let’s set aside the probability of getting accepted and Desperate Housewives tales.)
Once the goal is defined, you can define the risk and ask yourself: how do I increase the probability of reaching my goal? You reduce the possibility of reaching a bad outcome. In the retirement example, you do that by investing in an asset class that gives you the highest probability of great long-term returns, which is equities.
Over long periods, equity investments have given the best returns. Pundits suggest that equities might be expensive today, but, if you are willing to hold them for the long term, this should have little influence on your decision to invest.
Alexander Forbes Investments noted in a recent study spanning the past 60 years that the average real (after-inflation) annual return for holding the FTSE/JSE All-Share Index for 20 years was 9%. The minimum was 5%, the maximum a staggering 13%.
On the flip side, cash was shown to be one of the worst investments over the long term. Over the same period, the average annual real return on a 20-year investment was 2%. The minimum real return, however, was minus 1%, while the maximum was 5%.
It’s interesting that the maximum real return on cash equaled the minimum real return on equities.
If you are saving for the long term, for retirement, and you want to maintain your standard of living in retirement, cash is risky. The worst outcome in equities might well be the best outcome you can expect in cash.
As in relationships, having a long-term view will increase your chances of success. Besides, where is the fun in a relationship without a little volatility? Not the Desperate Housewives type of volatility – that is akin to saving for your child’s education in Bitcoin!
Hannes Viljoen, CFA and a Certified Financial Planner, is CEO and head of investments at Kudala Wealth in Johannesburg.