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31 March 2020

Even cash can be risky

Sonnie Bailey

It’s not fun being asset poor and cash poor. It’s rarely fun to be asset rich and cash poor, either.

Times like this put the problems of being “cash poor” into starker contrast.

For many people right now, the difference between feeling comfortable and uncomfortable is having cash on hand.

If you’ve got cash on hand, congratulations! You’re probably feeling better than most Kiwis.

However: there are risks with holding cash, and they are more pronounced than usual right now. The purpose of this article is to explore some of these risks and how to manage them.

(Spoiler alert: my conclusion is the same as always. The best way to manage most investment risks is diversification. Have your eggs in lots of baskets.)

No investment is safe

I’ve been saying “there’s no such thing as a safe investment” for a long time.

When it comes to investing in “safe” investments such as cash, savings accounts, and term deposits, for instance, I’ve long stressed that investing too safely can be risky over the long-run.

But in this article, I will cover a couple of other risks: bank failure and hyperinflation.

The widening range of possibilities

The immediate concern over the coming months and years is COVID-19 and avoiding unnecessary death and suffering. Another pressing concern is making sure people whose livelihood has been disrupted can eat and support their families without becoming homeless.

As time goes on, and we adapt to a “new normal”, there will be other concerns. Some industries may be wiped out completely  – they won’t be able to survive sustained waves of social distancing (hospitality?), and reduced demand may reduce the viability of these industries (certain forms of tourism?). Some industries and ways of working might change profoundly.

We’re in a state of major uncertainty. There’s risk, opportunity, and challenge ahead.

Another way of thinking about this uncertainty is that the range of possible scenarios in front of us is much wider than usual.

The purpose of this article is to consider some scenarios that might usually be considered “out there” or extremely unlikely. As I write this, I think they’re still unlikely. But the possibility of these scenarios occurring is much higher than usual.

In a sense, they point to added risks associated with investing in cash.

Bank failure

It’s hard to believe I’m writing those words. I still think the likelihood of one of the big banks failing in New Zealand is very low. If that happened, we would have even bigger issues.

However, bank failure happened in other developed countries during the GFC, and I’ve had several people want to at least know how you might manage this risk. This article is thinking about worst-case scenarios.

Like them or not, banks are systemically important. If they halt, the entire money merry-go-round stops.

If you have a savings account with a bank, or a term deposit, or any other form of “liquid” fund, in ordinary circumstances it’s as good as having cash in your hand. (Possibly even safer: your wallet can always get stolen, and the money under your mattress can go up in flames.)

These will be tough times for banks. There will be a lot of people who won’t be able to make debt repayments at the moment. This means less cash is coming in. This means they have less to lend. This also means they have less capital.

If everyone wanted to withdraw their funds from a bank at the same time (a “bank run”), no bank would be able to do this at short notice. This is because they use the funds that you deposit to lend to other people. Their ability to satisfy withdrawal requests comes down to everyone not making a request all at once, because there is a mismatch between when they can access some of the funds that they’ve loaned out. (A bank can’t easily go to someone with a 30-year mortgage and tell them they have to repay their mortgage at short notice.) For this reason (and others), banks have capital adequacy requirements, which are regulated by central banks such as the Reserve Bank in New Zealand. My understanding is that the banks in New Zealand are relatively well capitalised compared to banks elsewhere in the world.

Despite this, it’s a major concern for some people. Several of my clients have contacted me with this specific concern.

If this is a concern, this is a situation where it might be best to invest funds with multiple institutions rather than one institution. Specifically:

  • You could spread some of your funds across multiple banks/institutions.

(IF a deposit guarantee is announced by the Government, it is likely that this guarantee is going to be capped at a certain level, and might have some other terms and conditions. Depending on the terms of the guarantee (let’s say it is $100,000, and you’re wanting to invest more than this) the prudent thing might be to have no more than $100,000 invested in any one institution. It would depend on if, when, and the details, of any guarantee.)

One thing to keep in mind: a convenient way of investing in term deposits with multiple institutions is via InvestNow, which allows you to invest in term deposits with multiple institutions from the one platform/interface (and with only one set of AML/CFT forms), rather than have to deal with various institutions individually.

  • Another is to invest in a managed fund which invests in lots of different cash-like investments. The fund I’ve been recommending recently is SuperLife’s NZ Cash Fund. The fund is structured in the same way as a traditional managed fund: your investments are held by an independent trustee, which provides you with protection in case something happened to SuperLife. The difference between this fund and other managed funds (eg KiwiSaver “conservative”, “balanced”, and “growth” funds) is what this fund invests in. The underlying investments in the SuperLife NZ Cash Fund include various cash and cash equivalent investments. The return you get from this fund will be low. However, your investments will be spread across lots of different types of investments, so if there was an issue with one, the other investments are likely to be unaffected.
  • Investing in one or more bond funds (such as Simplicity’s NZ Bond Fund) might also be an option. However, I wouldn’t be surprised if there is more volatility in this type of investment. Bonds are very sensitive to changes in expectations relating to interest rates, and it’s anyone’s guess regarding what interest rates will look like in 12 months or more. This being the case, there are likely to be a fair amount of ups and downs in the value of bonds  – although not nearly as much as with shares. (One thing that might give you with greater confidence with bonds, however, is that many bonds are issued by Governments, which have a much broader range of options available to them for repaying bonds.)

It may also be worth holding wealth in other “liquid” ways. Like cash, or other assets that can be sold or bartered.

Hyperinflation

Inflation eats away at the purchasing power of your money. Hyperinflation is when this happens really quickly.

Governments are usually considered “safe” because they have lots of options for funding their activities that aren’t available to any other entity. They can, for example, print money.

If a Government prints money, but the underlying value of assets in the country stays the same, then inflation happens. Basically, you have the same amount of stuff and more money to buy it with. If the Government prints a lot of money, you might see higher levels of inflation.

High inflation means high uncertainty. If you’re in business and something that costed you $100 is likely to cost you $110 next week, then you’ll have to put your prices up in order to make up for these increased prices. Your staff will also want or need to be paid more because their salary will buy less this week than it did last week. And so on. Prices spiral upwards.

This is great if you have debt! If we ignore interest and repayments, a debt of $500,000 today might still be $500,000 in two years’ time, even if your income has increased from $50,000 to $100,000 to keep up with other costs and expenses. If you own a house… you might not want to sell it because of uncertainty around what you’ll get and what you’d need to pay for the next house… but at least you own something that is valuable that is likely to increase in value in line with inflation.

But hyperinflation is terrible if you have a lot of money in cash. If you start off with $500,000 in the bank, you might still have $500,000 in your account after 12 months, but it might only be able to buy the equivalent of $400,000 at the start of the year.

Don’t get me wrong! As I mentioned at the start of this article, it’s great to have cash in times like this. You can’t eat your house and all.

But there are risks to holding all of your wealth in cash.

The question then, is what do you invest in?

Gold?

One of the first answers for many is gold. However, I’m sceptical of gold as a form of investment. I basically see it as a historical antecedent to cryptocurrency.

Over the long-run gold doesn’t generate much of a return. It’s also only inherently valuable because other people think it’s valuable. From one important perspective, it’s a terrible investment: a good rule of thumb is “would I want to make this investment if I could never sell it?”. Gold doesn’t generate an income like property (rent) or shares (dividends). Most of its value is based on everyone else believing it’s valuable, which is a weird version of musical chairs or greater fool theory.

The other thing about gold prices is that the market for gold is a big one. As with shares, gold prices reflect a consensus view of many people’s expectations, with the big buyers and sellers being people who invest in gold professionally. I understand gold has increased in value recently. The reason it has increased in value is because there are many people who are thinking it will hedge against inflation. The price of gold, like the price of a publicly listed share, represents the consensus value of lots of people making predictions about the future. As with the share market, I’m sceptical about anyone’s ability to beat the “wisdom” of this crowd.

Beyond gold, what is there?

Property is a great hedge against inflation. In hyperinflation, people with property could potentially benefit.

Having said this, there are practical issues with property during normal times, and especially during hard times. What are you going to do if and when one of your residential tenants says they can’t pay the rent this month? If you own a commercial property, what are you going to do if your tenant can’t make lease payments or goes out of business? Ordinarily, you might have the option of finding another tenant. It’s not so easy right now.

Despite this, property should generally be a relatively sound hedge against the specific risk of hyperinflation.

Guaranteed income funds might seem attractive, but unless they protect against inflation, they are terrible because the income you’re being guaranteed will start to be basically worthless. It has been one of my major concerns with guaranteed income funds in NZ from the start.

Investing more aggressively might also help hedge against inflation. If you’re invested conservatively – in other words, in cash and bonds – in the event of hyperinflation, the value of these investments are likely to reduce substantially. If you’re invested in shares, at least you have an interest in a business that might be able to survive (or thrive) in this new environment.

On the other hand, deflation is part of the range of possibilities, and that may be good for cash

We’re familiar with inflation. This is where the price of goods and services increases over time.

But deflation is also a possibility. This is where the price of goods and services falls. In this case, $1 now will buy more in the future rather than less.

COVID-19 could prompt a deflationary cycle. For instance, let’s assume that unemployment rates rise substantially. Fewer people will want to spend money, reducing demand for many goods and services at various price points.

Less people will be like this guy.

This could work with all sorts of assets: from small items, such as bottles of soft drink and bars of chocolate, all the way up to cars and houses. (If things get really bad, a lot of people will have to sell their houses. Banks will have to lend with much tighter lending policies to ensure they retain enough capital. So fewer people will be able to buy. All else being equal, increased supply + reduced demand = lower prices. Don’t forget the “all else being equal” part, however: these models are always over-simplifications.)

With a simple economic model, reduced demand results in a reduction in prices:

… which can lead to deflation when it happens to enough goods and services.

High inflation is scary because it reduces certainty about the future. However, I think deflation is scarier.

At least with inflation, there is an incentive for people to buy goods and services now, rather than wait until prices rise. This keeps the economic engine going. With deflation, people have an incentive to wait, because they’ll probably be able to buy items for a lower price if they wait. Similarly, taking on debt becomes especially scary – not only do you have to pay interest, but you run the risk of the real cost of your debt increasing in value over time. This has the potential to bring the economic engine to a halt.

Forgetting the bigger picture consequences of deflation, how does it impact us at a personal level?

The opposite holds true compared to inflation. Cash becomes more valuable. Bonds are likely to become more valuable. Property prices are likely to fall, and taking out debt isn’t such a good idea. Shares will probably reduce in value, to reflect the slowing the economic engine.

Boring conclusion #912: DIVERSIFICATION IS KEY

Who knows what will happen? Banks probably won’t fail, but it’s not impossible. Inflation might become hyperinflation, but deflation could happen. It’s also quite likely that neither will happen.

I don’t know what will happen, and, frankly, I don’t think anyone else does either. There are a lot of unknowns, including the devastation COVID-19 wreaks, and the responses of various Governments, central banks, and other actors throughout the world.

Even in “interesting” times, it feels like my conclusions are boring. It gives me some peace of mind that my message is the same during good times and bad.

To my mind, the key for protecting your wealth – and making the most of your situation – is diversification.

You shouldn’t have all of your wealth in one asset class. 

I have several clients at the moment, for instance, with several hundred thousand dollars (or more) in cash. One or more of the issues I’ve discussed in this article are big concerns for them.

In each case, however, I’ve been able to point out that while this is a large amount of money, it puts them in a good position over the short- to medium-term term, in terms of providing with the ability to meet their costs of living and keep their business operating without any immediate cash flow needs. They’re also in a good position in the sense that although this is a large amount of money, it only represents a fraction of their wealth, most of which is invested in other forms of assets.

Every investment has risks. Although my focus in this article has been risks associated with cash, it is not unique in that sense and in most cases is one of the least risky of all investments.

The key is to balance the risks to which we’re exposed in a way that is suitable to you. Diversification helps manage these risks.


Addendum: some other things to keep in mind

The last safe investment is you

Last year I wrote an article discussing a book that made the argument that the last “safe” investment is you, and your ability to be valuable to others.

This might not be a consolation if you’re not working and you can’t, or don’t have a strong desire to, re-enter the workforce. But for people who are younger, it’s a valuable message to keep in mind: if you have the skills, knowledge, contacts, and reputation that means you can create value and find ways to provide value, then you’re probably in a better position than most. At least you will be able to find work and generate an income to support yourself, regardless of the assets you own.

The most valuable form of capital is social capital

For most of us, our close relationships are our greatest sources of joy and despair. In good economic times and bad, we need to invest in our relationships.

If you’re in a position where you have loved ones who you can help out, and who are prepared to help you out, then you’re rich indeed.

It may be too late this time around. But before the next crisis, make sure you’re like George Clooney and dig the well of friendship and kinship before you need to drink.

 


Tags

bank failure, cash, deflation, hedging, hyperinflation, investing, investment risk


About the author 

Sonnie Bailey

In his spare time, Sonnie likes telling people that he’s a former Olympic power walker, a lion tamer, or that he is an orthodontist. He is none of those things. In reality, Sonnie is a financial planner based in Christchurch. Through his business, Fairhaven Wealth (www.fairhavenwealth.co.nz), he provides independent, advice-only, fixed-fee financial planning services. Sonnie is a “recovering lawyer”: he has specialised in trusts and personal client work. He has also worked as a financial services lawyer for many years.

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