Interest rates in the developed world have fallen to historically low levels and if you are holding significant amounts of cash in your portfolio you are seeing your income reduce dramatically.
I entered 2008 with 70% of my portfolio in cash. By the end of January 2008, I had moved to 80% cash. As a result of this very conservative allocation, I avoided the worst effects of the 2008 crash. I still have a very significant weighting towards cash, but it’s making me increasingly uncomfortable.
The reason that I’m now feeling uncomfortable with my cash investments is that I know I’m effectively “lending” my money to banks at a negative real interest rate. That is, the interest rate that I’m receiving is now less than the inflation rate.
Anyone that does this over time will ensure that his or her standard of living declines. It will happen slowly and as a result is not immediately noticeable, but as sure as night follows day, the investor’s financial position will steadily deteriorate.
Here is what Warren Buffett said on this issue in The New York Times (October 2008):
Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.
The threat of high inflation (after a period of deflation) is a very real risk due to the wanton spending of Governments around the world. The bad news for investors in equities is that equities will not do well in a deflationary environment and they will also not do well in an environment of high inflation. Equity markets like low levels of inflation – they don’t like much else.
Nevertheless, the dividend yields on some high quality companies are now well above cash rates (and the inflation rate). Even if the shares prices of these companies remain at current levels for several years (while more or less maintaining current or somewhat reduced dividend levels), the investor who purchases shares in such companies is almost certain to come out ahead of those taking the cash or bond option – provided they can tolerate the volatility.
I‘ve been gradually increasing my exposure to equities. Obviously, I can’t speak for all markets, but it is my belief that my home market will not decline significantly from the lows that have already been seen. Maybe those will be famous last words! However, I’m putting my money where my mouth is.
There have been several companies that I have long admired and always wanted to own shares in. The problem was that these companies normally traded at prices that (in my opinion) were above intrinsic value and this precluded me from buying them. The crash of 2008 changed that and I have been gradually purchasing some of these companies.
At the moment, I’m more concerned about holding large amounts of cash (which is effectively costing me money) than the ongoing weekly fluctuations in my share portfolio (which is comprised of sound dividend paying companies providing goods or services in essential sectors of the economy).
The difference between those that achieve financial independence and those that do not is that the former group are much more willing to take calculated risks when the odds are in their favour. Increasing exposure to equities at this time is a calculated risk, there is definitely potential downside but there is also potential upside (I’m sounding like a business journalist there!).
There is nothing that is certain in life and time will tell. Personally, I‘m prepared to patiently back equities, I think patience will be required. It could take several years for global markets to emerge from the current crisis.
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