23 June 2016
Could cash be king?
by Frank O’Nomics
There is a point in the classic film (of the play) Glen Garry Glen Ross when the top real estate salesman (played by Al Pacino) derides the leads being given to him by his office manager (Kevin Spacey), using the phrase “money in the mattress”. The problem now seems to be that, against a number of asset classes, keeping your money in a safe place (admittedly in a one year fixed rate deposit account rather than your bed) has provided you with better returns, at least over the medium-term. If this is correct, and has to be treated as a reasonable prospect when assessing future returns, we will have to fundamentally review our decision making process, given that, for example, we often choose an equity ISA for better prospective long-term returns as opposed to the safety of a low returning cash ISA. Taken further, we expect the money that we put into a pension fund to be invested largely in equities, at least in the early years, because the long-term returns should give us a better retirement than parking the money in a cash savings account. If this is not the case, then why are we investing in a pension?
Broadcaster Paul Lewis has looked at returns from equities since 1995 and compared them to the best 1 year cash deposit. He demonstrates that, in any 5 year period since then, the cash deposit would have produced a better return 57% of the time. Over any 14 year period the outperformance by cash is more marked, delivering better returns 96% of the time. Only when you look at periods greater than 18 years do shares consistently outperform cash, but even if you take the full period (from 1995-2015) the compound growth rate of equities is only 1% better than that of cash, hardly reflective of the generally accepted view that the “risk premium” required for owning equities instead of cash should be around 3% – equities have to pay out more to account for their greater risk and reduced liquidity.
Does this mean that we should be selling all of our equities and putting the money in a fixed-term deposit? Despite the current high levels of uncertainty in the markets, I believe the answer to be a resounding no.
At the outset, it is worth adding some weight to the argument for cash. While cash rates are much lower than any historic norm, they are positive in a real sense (ie net of inflation), as long as you can accept a 1 year term, and for many the interest received will not now be subject to tax. As for equities, while management charges have been reduced, they do still have an impact on returns, and many will not want to accept the risks involved. If you have £1000 and are presented with an equal probability of having £1100 or £900 after one year, or having £1001 guaranteed, many would opt for the safe option. In fact research has shown that, on balance, households would accept a small fall in the value of an investment in exchange for taking out a greater risk of downside. It is only when there is a prospect of greater returns that investors will be happier to hold equities. Risk aversion is not a stable phenomenon and will vary across income groups and over time. If the current equity risk premium is deemed to be too low for the perceived level of risk aversion, then the price of equities will fall.
Turning to the reasons why we should not be turning our backs on equities, we should first look at the historical analysis, which is nothing more than that – just history. The last 20 years have seen some major upheavals for the investment industry, most notably the dot com crash of 2001 and the financial crisis of 2008. Any assessment which includes these periods will inevitably show that equities provide a poor risk reward ratio, but this should not suggest that similar events are likely to occur again with the same regularity. If one looks at total returns over a much longer period, equities win out quite dramatically; from 1951 to 2014, £10 invested in UK equities would have become £850 as opposed to just £500 invested in short-dated bonds (using them as a cash proxy).
Secondly, the point from which we currently start is very different from the 1990’s. Even as recently as 1998, a one year cash deposit was offering 8% per annum, but the best one can find now is comfortably below 2%. Such low cash yields may look acceptable with inflation likely to remain so low for some time, but they do not look attractive when compared to the dividend yield on equities, which is near 3.5%. While this does suggest that, at nearer to 2% (3.5% for equities minus 1.5 for cash) the equity risk premium is still below levels where equities are conventionally seen as attractive, the abundance of savings needing to find a home can support this reduced level for some time. If we see interest rates available on cash deposits as remaining lower for longer (markets suggest UK rates will do little for another 3 years at least) then the compounding effect of 2% difference will make a very big difference to total returns over that longer period.
Perhaps the biggest argument for holding equities rather than cash is one that supports the investment industry as a whole. The analysis used by Paul Lewis uses the returns for equities resulting from buying an index-tracking fund, which effectively mirrors the performance of the FTSE 100. The story is very different if one looks instead at the performance of an actively managed fund. The Association of Investment Companies has pointed out the substantial outperformance of the average investment company versus cash over most periods longer than three years. We may not all be star fund managers, but there is evidence to suggest that utilizing those that are will generate long term rewards.
This last point is perhaps the most crucial. What Mr Lewis’s analysis helps us to do is to ask the right questions of our investment managers, and particularly those charged with managing our pensions assets. We should not be paying active management fees for those who merely manage to mirror the performance of FTSE and we should be targeting, at the very least, returns that consistently beat those of a one year cash deposit. At a recent Gresham College lecture, Professor Jagjit S Chadha pointed out that savings are merely a way for households to smooth their consumption patterns over time – we save more while we are working so that we can sustain our lifestyle once we retire. If we rely on a return of 1.5% on our savings to fund our retirement we are all likely to be working for a very long time.
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