As investors, we have great difficulty valuing cash correctly. We take shortcuts and seldom analyze things from more than one point of view. Understanding the value of cash, from different angles, can help you make better decisions with your money.
What’s The Yield?
Oftentimes when we value cash, we simply want to know what it pays – the interest rate or yield. This can be deceiving. The rate quoted by all institutions is what is called the nominal rate – it is the rate you receive. We should also consider how much that cash will allow us to buy in the future. This is known as the real return, or how much it really affects you. We take the nominal rate and subtract inflation for the real return.
In the current period of low interest rates, it is not uncommon to find savings account paying 0.50% or less – that is the nominal rate. Subtract inflation, let’s say it's a measly 1.50%, and you have a real return of -1.00%. You are losing purchasing power on each dollar of cash! The instant analysis is, “Holding cash is of negative value.” That is correct in this situation, but not in all situations. We need to look at many angles when making financial decisions to ensure we make the right one.
“Cash is King”
This saying seems to come about every few years when the economy is having a tough time. While we learned above how cash can be a drag on your future purchasing power, I will now make the case that the same cash can be a great advantage to an investor.
Most investors agree with the adage, “buy low and sell high”. But we don’t often talk or plan how we are going to do that. We presume that someone will ring a bell when stocks are at a low and sound the buzzer when stocks are at a high. Assuming we can emotionally buy low (that is a big assumption), what are we to buy stocks with? Of course we need cash. And this is where the value of cash can come as an opportunity.
An investor who holds no cash because it has a negative real return, will not have any cash to buy stocks at a low price. So we must ask ourselves, what is the cost of the real return and how does that compare with the potential return from buying low? Are we willing to give up a few percent for the opportunity to buy quality assets on sale? That, like most financial decisions, is the tradeoff.
Remember that the first decision you come to may sound right and may even be right in your circumstance. But before acting on any financial decision, be sure you are also evaluating it from different angles. You may come to a different conclusion. The important thing is that you come to the right conclusion.