Cash is king?
IN the realm of personal finance, the adage “cash is king” has long been debated. While holding cash ensures liquidity and security, it often comes at the cost of lower returns, especially in traditional savings accounts.
This article explores the strategic importance of cash in investment portfolios, the necessity of continuous reassessment of cash holdings, and the role of seemingly safe investments like the Fiji National Provident Fund (FNPF) in striking a balance between security and growth.
Building upon my previous articles about the importance of savings and investment, and exploring the diverse investment options in Fiji, this article delves into a crucial aspect of personal finance: the role of cash in an individual’s investment portfolio.
Contrary to the common belief that effective investment strategies require a substantial initial capital, I emphasise a fundamental principle: investment decisions start from the very first dollar saved.
In this discussion, we investigate the oftenoverlooked importance of cash holdings within a well-balanced investment strategy.
Acknowledging that cash is more than just a passive asset, let’s explore its dynamic role in providing security, flexibility, and the foundation for informed investment decisions.
My focus extends to how individuals, regardless of the size of their savings, can judiciously manage cash as part of a comprehensive approach to financial planning, ensuring that every dollar is strategically employed towards achieving their financial goals and aspirations.
The crucial role of cash
Cash holdings serve as the bedrock of financial security. Renowned investor Warren Buffett’s advice to prioritise savings over spending underscores the need for an emergency fund.
Cash provides a buffer against unforeseen expenses, negating the need to prematurely liquidate investments, which may incur losses or additional costs.
Cash also keeps you ready to invest should an attractive investment present itself.
However, holding too much cash, particularly in accounts with minimal interest accrual, can lead to a loss of purchasing power over time due to inflation.
Determining the optimal cash allocation
Determining the right amount of cash to hold is a dynamic and personal decision, influenced by age, risk tolerance, financial goals, and market conditions.
Younger investors, with a longer investment horizon, are generally advised to limit cash holdings, favoring investment in higher-yielding assets.
This approach aligns with the principles of compound growth and long-term wealth accumulation.
In contrast, as individuals approach retirement, increasing cash holdings can offer greater stability and immediate fund accessibility.
Investment guru Ray Dalio highlights the importance of a strategic asset allocation mix, adapting to one’s changing financial landscape. Regular portfolio reviews and adjustments in cash allocation are essential to align with life changes and economic shifts.
While maintaining an emergency fund in cash is prudent, it’s equally important to seek balance with other investments.
A diversified portfolio — including real estate, long term deposits, superannuation and stock and bonds (if possible) — can offer better protection against inflation and potential for higher returns.
The key is to find a balance that suits one’s personal financial situation and goals.
The power of compounding
Here at home, the FNPF offers an intriguing option for investors.
Last year, it paid a seven per cent interest to its members, a rate quite attractive compared to traditional savings accounts.
However, FNPF investments come with a significant drawback: liquidity.
Once invested, there are several criteria to be met for funds to be withdrawn.
This lack of flexibility highlights the trade-off between higher returns and accessibility, a crucial consideration for any investor.
However, if you have funds to spare, consider the power of compounding.
Compounding interest is a powerful factor in long-term investments, often referred to as the cornerstone of wealth accumulation.
To illustrate its impact, consider a more modest initial investment scenario. Assume in your first year of employment, you struggled and managed to save a $1000 (refer to Graph A).
Now assume you invest this with an annual interest rate of five per cent.
Over an extended period, let’s say 45 years (your average working life), the effect of compounding becomes remarkably significant.
In this scenario, the interest in the first year would be $50, increasing the total investment to $1050.
In the second year, interest is calculated on this new amount, resulting in an interest of $53, and a total of $1103.
As this process continues year after year, the interest is compounded on an increasingly larger base —the original amount plus the accumulated interest.
After 45 years, with an initial investment of $1000 and an annual interest rate of five per cent, compounded annually, the investment would grow to approximately $8985.
Without any additional contributions, the final amount is substantially larger than the initial investment, illustrating how even a small initial amount can grow significantly over a long period, thanks to compounding interest.
This example highlights the importance of starting early and allowing time to work its magic, making compounding interest a critical component in long-term investment strategies.
However, while the growth of an investment from $1000 to approximately $8985 over 45 years because of compounding interest appears impressive, it’s crucial to consider the impact of inflation on the real value of this investment.
Inflation refers to the general increase in prices and fall in the purchasing power of money over time. Essentially, a dollar today will not have the same purchasing power 45 years from now.
For example, if the average annual inflation rate is two per cent, the value of money decreases correspondingly each year.
After 45 years, the cost of goods and services would be significantly higher, meaning the real purchasing power of the $8985 would be less than it appears in today’s terms.
To calculate the real value of the investment, one would need to adjust the future value of the investment for inflation.
The adjusted value represents what the future amount would be worth in today’s dollars, giving a more accurate picture of the investment’s true benefit.
If we apply an average annual inflation rate of two per cent to the future value of $8985, the adjusted value would be considerably lower.
This adjustment is essential in long-term investment planning, as it provides a realistic view of the investment’s potential and helps in making more informed decisions.
It underscores the importance of selecting investment options that not only grow but also outpace inflation to ensure the preservation and enhancement of the investment’s real value over time.
In the illustration below (refer to Graph B), we can see that even though the value of the investment has increased by more than eight folds in 45 years, the real buying power of the investment have just increased three folds.
The continuous review of cash holdings
The financial world is everchanging, and so are personal circumstances.
Regularly reviewing and adjusting cash holdings in response to these changes is critical.
Investment expert Peter Lynch’s advice to understand and continually reassess one’s investment choices applies aptly to managing cash in a portfolio.
This ongoing process ensures that an individual’s financial strategy remains aligned with their evolving needs and goals.
Conclusion
While cash is an essential component of any investment portfolio, offering safety and liquidity, its role should be carefully balanced with other investment vehicles to achieve a mix of security and growth.
The example of FwNPF in Fiji demonstrates how seemingly safe investments can offer attractive returns, albeit with certain limitations like reduced liquidity.
Ultimately, the decision of how much cash to hold is personal and should be continuously reviewed, taking into account individual circumstances, market conditions, and personal financial goals.
The art of balancing cash with other investments is key to navigating the path to financial security and prosperity.