As investment markets melted under the heat of sharp and seemingly relentless central bank interest rate increases over the last year, investors have taken shelter under the relative protection of cash and short-term investments. And while these instruments can be appropriate for an investor in the short-term, for the long-term investor cash often provides poor net returns, while also creating the risk of lost opportunity as markets turn higher.
Cash is king in the land of the blind(sided)
There is a general truism in investing that when markets are on the downswing and volatility is causing investors headaches, cash is king – or, in short, cash is the best place to take refuge and hideout until markets regain their footing.
As central banks have jacked up interest rates far beyond expectations in an effort to combat persistent inflation, the interest rates paid on cash deposits and short-term cash-equivalent instruments like T-bills, High Interest Savings Accounts (HISAs) and Money Market funds have soared to the 4%-5% range, providing a decent return for volatility-scarred and jittery investors.
It's all about the net, not the netting
When we consider our returns on an investment, it is important to note that your return is more than what an asset has generated for you over a certain period. Your return is all about what you net after inflation and taxes – in short, what you net, not just what you seemingly netted or earned.
Real after-tax return = Nominal return - taxes - inflation
Assuming an investor is earning a nominal annualized return of 5% in their cash or cash-equivalent investments these days, if we then subtract the annualized inflation rate that stood in the month of April 2023 of 4.4%, the net after inflation annualized return would be 0.6% (5% - 4.4%).
Even worse, assuming the funds are held outside a tax-sheltered savings account such as an RRSP or a TFSA, that means paying taxes at the investor’s top marginal tax rate on your nominal return (interest income is taxed at your top marginal tax rate). In short, this would cut down your 5% nominal return by as much as half, meaning an after-tax return of 2.5%; and, then accounting for inflation’s impact, your return actually turns to a negative 1.9% (5% - 2.5% - 4.4%). Hardly a comforting return when you consider all these factors.
It’s cold on the sidelines – staying on track to your investment plan
For a long-term, risk-appropriate investor whose investment plan’s success is predicated on them remaining invested through all market conditions, another downside of moving to cash during volatile and difficult periods in the market is the danger of missing out when markets rebound and regain their forward momentum. Based on history, markets have always risen over time, so to move to the sidelines is to risk losing potential important returns.
This is particularly true these days. Interest rates have begun to peak, so it’s important to note the historical reaction from markets and the impact on investors in the months that follow a peak in central bank hikes, as illustrated here:
Note that in eight of the last ten circumstances such as the one we face today, markets were sharply higher one-, two- and three-years after the final interest rate hike of a tightening cycle.
No better time than the present to get back on track – we can help
There are times when an investor may justifiably want to move to the sidelines and wait out volatile markets, even if it means just getting a good night’s sleep. But the cold comfort of cash is historically something to do for - at most - very short periods of time.
If you have sought the seeming comfort of cash but want to get back on track , talk to us today – we can help bring you and your portfolio back in from the cold.
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