Cash hits bottom

Wealth is, at its most basic level, a measure of value. Or rather a measure of relative value. Reasons for accumulating it can vary according to whatever stage of the lifecycle someone is in – and obviously any list isn't exhaustive.

When you boil it down, though, most of the reasons for accumulating it come down to the following: security (health, food, housing), enjoyment (holidays and consumer goods), status (to live and for your children to live in a ‘good' suburb with good schools, etc.) The list could go on… but the point is, there are sound, sensible reasons for people to try and maximise their wealth and, importantly, to preserve it.

A key dilemma we face is how to accumulate and protect wealth without taking on excessive risk. The problem is compounded by the fact that the real risk free rate of return is effectively zero. Less than zero in some cases. This changes – has changed – the landscape or the rules considerably, especially when it comes to protecting your wealth.

Unfortunately the first rule is that in order to have a chance in preserving wealth in this environment, people have to risk it.

I'm not talking about taking risk to accumulate wealth here – or maximising returns. I am simply talking about wealth preservation.

Of course people are free to do as they wish. But for those who don't want to take risk, then they must accept that their relative wealth will decline. I'm not saying I support this, or that this is great policy or anything. It isn't and I have long argued against current policy settings. It is our reality though and people have a choice as to how they will respond to these circumstances.

Why holding cash no longer protects your wealth

I have to confess at the outset that I get a lot of resistance to the idea that cash isn't a good investment. I'm constantly accused of being either a spruiker for whatever industry, or a gung-ho cowboy who lacks an appropriate appreciation for risk. This isn't true.

Cash simply isn't the investment it once was. It's not even a question of risk preference. So while there are a number of good arguments against holding cash – and I outlined one of them in a recent piece – my key argument against cash is that it is no longer a good store of value. It used to be, this is true. Now, however, holding cash does not preserve wealth.

Have a think about some of the major purchases you make, whether they be investments or expenditure items. While general inflation isn't doing much – food price growth is low and electronic gadgets get cheaper by the day – against some of the biggest purchases we make the value of cash has declined markedly.

Are people richer or poorer for having held it when the average return to cash accounts has been around 3.5 per cent over the last couple of years? Let's look at the facts:

• House prices have increased by 28.7 per cent in Sydney, 14 per cent in Melbourne, 11 per cent in Brisbane and 9.6 per cent in Perth. Returns to cash have only just offset prices gains in Hobart and Adelaide – and not even on an after tax basis.
• Education costs have increased by nearly 11 per cent and health costs have lifted by close to 9 per cent. The real increase could be even higher as some of these items may be subject to ‘quality' adjustment by the Australian Bureau of Statistics (ABS) which acts to dampen price increases.

Clearly against those items cash has lost its value – any given dollar purchases less of any of those items today than it did only 2 years ago.  Don't forget that rates are even lower now, and perhaps set to fall further as is the relative value of cash.  That this is occurring against many of the major items that we purchase to either accumulate wealth or which directly affect someone's quality of life, their standard of living and thus their relative wealth is a serious problem.

It's even worse when you look at financials assets. While cash has returned just over 7 per cent these last couple of years, equities are 21 per cent higher and bonds 11 per cent. Effectively each and every dollar in the bank now buys less property, less in equities, less in bonds and less of just about everything that matters for wealth.

Of course, whether this situation persists or not depends on the outlook for interest rates. Personally I think they should be higher – but a wealth preservation strategy can't rely on hope. If the circumstances change, then change the strategy. But that doesn't seem likely with what we know. The Bank of Japan has had zero rates for nearly 20 years, the Fed for about six years and, in Europe, the experiment has just started.

For my money a prudent wealth preservation strategy would acknowledge these facts and not live in hope that the past will repeat itself.  For now the fact is cash is not preserving wealth.