One of the common mistakes that individuals make regarding inflation is to assume that current inflationary pressures are now permanent. As shown below, while bouts of inflation can last for extended periods, it is never permanent. Notably, periods of “spiking” inflation lead to recessions and deflation, as consumption contracts and economic growth slows.
In the 60s-70s, rising inflation got offset by high savings rates, strong economic growth, and low household leverage. The current bout of inflation is the direct result of monetary interventions creating excess demand versus supply. However, while economic growth got an artificial bump, household savings are low, coupled with high household leverage.
The consequence of a decade of monetary policy by the Fed forced “savers” into “risk assets” by pushing rates to zero.
With “zero interest rates” on savings, and inflation running nearly 8% as of this writing, it is no wonder that many believe “cash is trash.”
However, that isn’t necessarily true.
Let’s start with the obvious. Inflation directly impacts your purchasing power parity over time. For example, I have savings in my bank account solely for the purchase of food and gas. Today, I can buy one tank of gas and a whole week of groceries to feed my family. If prices rise, I can still buy one tank of gas, but only 4-days of groceries for the same amount of money.
In this example, my “savings” need to grow by a rate sufficient to pay for an additional 3-days of groceries. Notably, this is how we tend to view our “savings” in their entirety.
However, there is an essential distinction regarding our investment accounts.
In our portfolio accounts (IRAs, 401ks, Taxable), the “savings” held ARE NOT for buying groceries, gas, or clothing. Those funds are there to invest in assets at times that we believe the rate of return on our capital will be higher than the inflation rate.
Notably, during periods of spiking inflation, asset prices tend to experience “deflation” and become cheaper, thereby increasing the purchasing power parity of our cash.
As is always the case when it comes to investing, capital preservation is always the most important. However, in periods of high inflation, holding “investment cash” can be a benefit as the purchasing power of that cash increases as asset prices decline.
When it comes to the “cash is trash” argument, the intended use is critical to the discussion.
Such brings me to something I discussed previously but is worth repeating.
In portfolio management, you can ONLY have 2-of-3 components of any investment or asset class: Safety, Liquidity, & Return. The table below is the matrix of your options.
The takeaway is that cash is the only asset class that provides safety and liquidity. Obviously, “safety” comes at the cost of the return. However, during a period of capital destruction or inflation, the “safety” of the principal becomes the primary goal.
But what about other options?
You get the idea. No matter what you choose to invest in—you can only have 2-of-the-3 components. Such is a crucial and often overlooked consideration when determining portfolio construction and allocation. Notably, the mainstream media doesn’t tell you that “Liquidity” and “Safety” provide options.
I learned a long time ago that while a “rising tide lifts all boats,” eventually, the “tide recedes.” I made one simple adjustment to my portfolio management over the years, which has served me well. When risks begin to outweigh the potential for reward, I raise cash.
I want to stress that I am not talking about being 100% in cash.
Being “all-in” or “all-out” of the market is never wise in the portfolio management process. While you may “time” the exit or entry perfectly once or twice, it is an impossibility to replicate it over time successfully. However, you can successfully manage risk by increasing cash during uncertainty or increasing risk when the opportunity is present.
As shown, we are holding higher cash levels because of the current uncertainty. That cash provides both stability and opportunity.
With the geopolitical, fundamental, and economic backdrop becoming increasingly hostile toward investors in the future, understanding the value of cash as a “hedge” against loss becomes dramatically more important.
For us, “cash is not trash” regarding portfolio and risk management.
But, since Wall Street doesn’t make fees on cash, maybe there is another reason they are so adamant you remain invested all the time.
Just something to consider.