Cash: Safe in the Short-Term, Dangerous in the Long Term
Contending with inflation, loss aversion, market volatility, and temporal bias.
The question of how much cash to hold has plagued investors since time immemorial. CNBC’s Jim Cramer recently estimated that $3–4 trillion in cash is waiting for an opportunity to enter the markets,
“There’s $4 trillion on the sidelines. We thought it was $3 trillion, but then we learned about an additional trillion sitting in money funds that can’t really stay there because their interest rates are so paltry, especially compared to high-quality dividend stocks,” Cramer said.
Currencies Only Go Down
History shows us that currencies move in one direction over time: down. A year ago, 7 Turkish lira gave you the purchasing power of 1 USD. Today, you need nearly 14 Turkish lira. The value of the USD is, in turn, plummeting in relation to most assets.
It is virtually a certainty that cash held will lose its value. Why then are we still so attached to cash?
There is a prevailing attitude that we must be prepared for an emergency, that we need to keep “dry powder” on hand. If you need money in the next 12 months, you should probably hold it in a stable currency rather than a volatile one.
However, although safe in the short term, cash is very dangerous in long term.
We have interest rates far below inflation. In fact, interest rates are effectively zero. If you were to hold $100,000 cash in a savings account today, you would have ~$46K in purchasing power after 10 years at a 7.5% rate of inflation. However, if you — like many intelligent people today — do not subscribe to the government’s CPI index, you probably understand that inflation is more than double the official rate. If inflation is 15% today, and persists at that level over the next decade, your hard earned $100K will be reduced to less than $20K in purchasing power, a greater than 80% loss on your savings.
The perception that cash is safe reflects our natural behavioral biases. The first is loss aversion. People hate losing money more than they enjoy making it.
The second is temporal bias. Humans tend to focus on the short term over the long term. But the short term has little, if anything, to do with investing. As humans, we much rather focus on safety and stability in the short-term at the expense of significantly larger gains in the long term. Otherwise, why hold cash? Cash is a certain loss in the long run.
Risks and Benefits of Holding Cash While Waiting for Market Opportunities
Beyond accounting for short-term expenses, cash can be held while waiting for new opportunities to deploy it. However, this comes with the caveat that you’ve exhausted all available attractive opportunities.
Warren Buffett uses cash in this way to manage investments for Berkshire Hathaway. The use of cash as an instrument for waiting has perplexed some Berkshire Hathaway shareholders. One such shareholder asked Buffett why he didn’t instead invest his greater than $100 billion cash pile into an index fund while he waited for a good way to spend it:
“Warren, you are a big advocate of index investing and of not trying to time the market. But by you having Berkshire hold such a large amount of cash in [treasury] bills, it seems to me you don’t practice what you preach. I’m thinking that a good alternative would be for you to invest most of Berkshire’s excess cash in a well diversified index fund until you find an attractive acquisition or buy back stock. Had you done that over the past 15 years, all the time keeping the $20 billion cash cushion you want, I estimate that at the end of 2018, the company’s $112 billion balance in cash, cash equivalents, and short-term investments in T-bills would’ve instead been worth about $155 billion. The difference between the two figures is an opportunity cost equal to more than 12% of Berkshire’s current book value. What is your response to what I say?”
Put simply, the question is: why did you hold onto so much cash for so long, when you could have invested in an index fund and obtained a sizable return, increasing value for your shareholders? There is an obvious opportunity cost to sitting on cash. Warren Buffett replied,
“It’s a perfectly decent question, and I wouldn’t quarrel with the numbers. And would say that that is an alternative, for example, that my successor may wish to employ because, on balance, I would rather own an index fund than carry treasury bills.”
Thus, Buffett agrees, in general, that holding an index fund is superior to holding cash. Why then, is Buffett doing the opposite?
“I would say that if we’d instituted that policy in 2007 or 08 we might have been in a different position in terms of our ability to move late in 2008 or 2009. It has certain execution problems with hundreds of billions of dollars than it does if you were having a similar policy with a billion or $2 billion or something of the sort. But it’s a perfectly rational observation and certainly looking back on 10 years of a bull market it really jumps out at you. But I would argue that, if you were working smaller numbers, it would make a lot of sense and if you’re working with large numbers it might well make sense in the future, at Berkshire, to operate that way.”
In other words, there are scenarios in which holding cash puts you at an advantage. Those who stayed invested in the market during the 2007–2008 housing crisis couldn’t take advantage of the financial carnage that ensued in the way Buffett did.
He also cites execution problems when working with large sums of money. It would be reasonable to assume that liquidation of $100 billion in assets over a short period of time could lead to extreme volatility especially in an evolving recession. Nevertheless, Buffett raises the possibility that Berkshire may have made some mistakes in holding such a large amount cash, and his successors may choose to take a different route once they assume the reigns.
“You know, we committed $10 billion a week ago, and there are conditions under which — and they’re remote, they’re not likely in any given week or month or year — we could spend $100 billion very very quickly. And if we did, if those conditions existed, it would be capital very well deployed and much better than in an index fund. So…we’re operating on the basis that we will get chances to deploy capital. They will come in clumps in all likelihood. And they will come when other people don’t want to allocate capital,” Buffett concluded.
An attractive opportunity could present itself in the future. Such an opportunity may present itself when others aren’t interested in buying assets, such as in a deep recession or, even, depression. Therefore, Buffett is willing to assume the risks of holding cash in exchange for being in the position to act swiftly and on a large scale.
Charlie Munger agreed with Buffett’s take while admitting that Berkshire may be too heavy on cash:
“Well, I plead guilty in being a little more conservative with the cash than other people. But I think that’s alright. We could have put all the money into a lot of securities that would have done better than the S&P, with the 20/20 hindsight. Remember, we had all that extra cash all that period if something come along in the way of opportunities and so on. I don’t think it’s a sin to be a little strong on cash when you’re as big a company as we are. I watched Harvard use the last ounce of their cash, including all their prepaid tuition from the parents, and plunge it into the market at exactly the wrong moment and make a lot of forward commitments to private equity. They suffered like 2 or 3 years of absolute agony. We don’t want to be like Harvard.”
Summary
The main issue investors are facing today is an acceleration in the rate of inflation. In the past, holding cash was deemed safe in the short-term. But what is short-term and what is long-term depends on how quickly the currency is debasing. One might say that the main attractive feature of cash is low volatility. There is certainty in knowing exactly how quickly your cash is losing value. With volatile assets, you have no idea what those assets will be worth in the short term.
On the other hand, it is an easy mistake to look at markets in nominal terms (i.e. the US dollar value) instead of real terms (i.e. the inflation adjusted value). The approach of investors like Buffett and Munger is one of calculated risk. They believe they can seize a rare opportunity of great upside if they hold onto cash.
But what if inflation gets out of hand? What if we see 20%, or 30% in the near future? In that event, holding cash is dangerous even for a single year’s duration. Short-term goes from several years, to months, or even weeks. In that situation, investors will be forced to reckon with their engrained loss aversion and temporal biases.