Have you ever considered what is cash? We all have some….
It could be in our wallets. In our purse. In our bank accounts. Or sometimes, in my case, in my trouser pocket that accidentally gets thrown in the washing machine. It gives a whole new meaning to money-laundering.
At its most rudimentary, cash is a medium of exchange. It is a convenient way for us to buy and sell things without having to resort to the tedious task of bartering. So, cash is, undeniably, useful.
But does its usefulness extend to holding it as part of our investments?
That would depend. The problem with cash is that it can lose its buying power because of inflation….
…. A two-dollar bill, for example, will still look and feel like a two-dollar bill in five years’ time. But if consumer prices are rising at 2% a year, that $2 will only buy us $1.80 worth of stuff after five years.
Put another way, the $2 has shrunk 10% in value. So, to maintain its buying power, cash must be put to work to ensure that its buying power will grow if not faster than the rate of inflation then at least as close to the rate that prices are rising as possible.
Safe as banks
There was a time when we could have earned some interest on any cash that we leave in the bank. That could have gone a little way to ease the damaging effects of inflation.
But not any more. Interest rates on our bank savings accounts pay nothing.
Near-cash equivalents, such as sovereign bonds, could be the next best thing to cash. But at the moment they don’t yield much either….
…. Another alternative is the stock market that has historically delivered inflation-beating returns. But shares can be more volatile than cash, which can be unsettling.
So, how much cash and how much should we have in shares? What is the right balance?
The answer is: it could depend on our appetite for risk.
Holding too much cash could be comforting, but it could also lower the returns on our savings. But too much in the stock market could leave us vulnerable to stock-market declines that can happen from time to time.
Thankfully, there is a rule of thumb that could help us solve the conundrum. It is called the “Rule of 100”. It is not perfect, but it could be a good place to start thinking about our asset allocation.
In a nutshell, the rule states that the proportion of our wealth in cash should be equal to our age in years. So, 30 year-olds should only hold 30% of their wealth in cash or near-cash equivalents. The rest should be in risk assets….
…. But we age, we probably want to assume less risk because we have less time to recover from a stock-market drop. So, a septuagenarian might want to keep 70% in cash and only 30% in risk assets.
But it is still only a rule of thumb. And not everyone’s thumbs are of the same length.
A full version of this article first appeared in Channel News Asia.
Get more stock updates on our Facebook page. Click here to like and follow us on Facebook.
Disclosure: David Kuo does not own shares in any of the companies mentioned.