Cash is king because it offers a superior return.
Treasury Inflation-Protected Securities (TIPS) have in recent times (this article was posted in September 2007) been paying a real return of between 2 percent and 2.5 percent, generally closer to 2.5 percent. The Stock-Return Predictor (see tab at left) reports the most-likely 10-year annualized real return of U.S. stocks at 0.84 percent. A real return of close to 2.5 percent is better than a real return of less than 1 percent. I’m sure of it!
The case that cash is king is that simple today. It’s a controversial truth, but it’s a simple truth all the same. The likely long-term return from cash is better.
Cash is king because it carries less risk.
It’s possible that stocks will provide a real return of far better than 0.84 percent. There’s even a 5 percent chance that the 10-year real return for U.S. stocks will be as high as 6.84 percent. So stocks really are better, right?
Not right. It certainly is true that the stock return is less predictable. We know that TIPS are going to pay their stated rate while there is a wide variability in the possible stock return. It’s dangerous to assume that that variability will work to your benefit, however. The down side is that the 10-year real return for U.S. stocks could drop as low as a negative 5.16 percent. We’re not talking about a one-time loss of 5 percent here. We’re talking about an average loss of 5 percent for every years for 10 years in a row. Not good.
There’s nothing wrong with purchasing an asset class of high volatility. Part of the reason why stocks generally offer such astounding long-term returns (at moderate prices, stocks offer a most-likely 10-year annualized real return of something in excess of 6 percent) is that stock prices are volatile. When they are thinking clearly (not the situation today!), most investors hate volatility and demand a risk premium for taking it on. Rational investors would not be willing to accept the risk penalty that applies for purchases of U.S. stocks today. The fact that the ordinary rules of stock investing have been turned on their heads should give you some idea of how far from the norm stock prices have traveled in recent years.
You might do better in stocks than you would in cash. It’s not likely. You could do an awful lot worse. You should be compensated for the price volatility you accept when buying stocks. Today, you are being penalized instead. Even considering the higher upside return potential of stocks, cash is king.
Cash is king because it allows you to retire sooner.
We’re a Retire Early community. We’re interested in how stocks compare to stocks during the accumulation stage of the investing life cycle because we need to accumulate wealth to be able to attain financial freedom early in life. We’re particularly interested, however, in how cash stacks up against stocks during the distribution stage of the investing life cycle. Could it be that cash is king today only in the accumulation stage but not in the distribution stage?
Our safe-withdrawal-rate investigations began with precisely this question in mind. The Old School safe-withdrawal-rate studies say that stocks always offer a safe withdrawal rate of 4 percent. Cash can often beat that, but as a general rule not by much. Stocks offer far superior long-term growth potential. So, if it were true that the safe withdrawal rate were a stable number, an argument could be made that it is not so that cash is king for those in the distribution stage.
It is not true that the safe withdrawal rate is a constant number. The Retirement Risk Evaluator (see tab at left) reports that the safe withdrawal rate for a portfolio of 80 percent stocks used in a retirement beginning today is 2.93 percent. It also reports that the safe withdrawal rate for a portfolio of 80 percent TIPS is 3.88 percent. Again, cash is king.
Cash is king because it generates larger income streams.
The reality is that few of us are solely concerned with how stocks perform during the accumulation stage and few of us are solely concerned with how stocks perform during the distribution stage. Most of us want to avoid losses to the extent possible in our pre-retirement years. And most of us want to achieve growth to the extent possible in our post-retirement years. Yet another way to assess whether cash is king is to look at the size of the income streams it generates.
John Walter Russell tells us what we need to know to do the analysis in the Tips Table page at his site.
At the height of the bubble in stock prices, TIPS were paying a real return in excess of 4 percent. Those who were smart enough to recognize that cash is king when it provides those sorts of returns own an asset class that provides for annual withdrawals of 5.78 percent for 30 years. Retirees might actually take those withdrawals. Pre-retirees might be happy just to watch their portfolio value grow larger and larger during a time-period in which those heavily invested in stocks are finding it a struggle to keep up with inflation. The stable return available from cash is not just a risk-reducer. In some circumstances, it’s a growth-enhancer too.
TIPS paying 4 percent real are not available today. If you stay alert to exciting investing opportunities, you might be able to pick up some paying 2.5 percent real, however. Those TIPS permit a 30-year withdrawal of 4.78 percent. That’s not speculation. TIPS are a no-risk asset class. That’s the withdrawal rate that will work in the event that the U.S. government does not fail to honor its promises.
Stocks benefit from the huge advertising budget directed to selling them to us. TIPS sell themselves. Cash is king when it comes to long-term income streams.
Cash is king because there are few realistic scenarios that can be imagined in which cash will fail to beat stocks.
Some people have a hard time accepting that cash is king. They can’t effectively dispute the numbers cited above. But they argue that it is possible that stocks will remain at extreme highs for so long that those who move to cash will end up regretting it.
This could happen. It’s very much a long-shot possibility, however.
William Bernstein (author of The Four Pillars of Investing) has written that the likely long-term return of U.S. stocks is 3.5 percent real. If you put your money in TIPS paying 2.5 percent real, and stock prices do not quickly fall enough to justify a move back into stocks, you will be lowering your return by about 1 percent real per year for the length of time it takes before we see stock prices return to normal levels.
It’s important to understand, though, that Bernstein’s analysis is based on the extremely far-fetched assumption that stock prices will never again return to normal levels; if we ever see a return to normal price levels, Bernstein’s wildly optimistic 3.5 percent return estimate goes out the window. It certainly is easy to imagine prices staying at extreme highs for one year or two years or three years or four years. But the return shortfall suffered by the cash investor would not be great unless stocks remained at extreme highs for far longer than they ever have in the past. And the other side of the story is that the historical data warns the stockholders of today to expect a 40 percent drop in portfolio value (this number includes the effect of dividends paid during the time prices are falling) in years to come. The 2.5 percent return available through TIPS will look awfully good during the years in which stock investors are experiecing a 40 percent loss of portfolio value as part of the process of working our way back to reasonable prices.
The downside potential of going with a high stock allocation is an ocean of pain and the upside potential is limited indeed. The historical data tells the same story again and again — cash is king.
Cash is king because it’s been performing well compared to stocks for close to 10 years now.
Some are unwilling to trust the message of the historical stock-return data. It is human nature for us to place more confidence in what we see take place before our eyes than in what we learn took place at earlier times in history. Some will not believe that a big drop in stock prices is coming until we have already seen it take place.
Guess what? It’s already in the process of taking place. Valuation levels are significantly down from where they stood in January 2000. There will of course be ups and downs in the days ahead. In all likelihood, however, the long-term trend will be for prices to continue downward until stock prices have dropped out of the red-alert-danger zone (that’s a long ways down from where prices stand today). They don’t often report this in the newspapers, but the Big Stock Crash that we arranged for when we permitted prices to get totally out of hand in the late 1990s has already begun.
Stock prices reached new highs recently. It means little. The numbers cited as new highs are not inflation-adjusted. A Dow Jones Index level of 13,000 today is not the same as what a Dow Jones Index level of 13,000 was in January 2000. Stock prices have gone up a bit over the past 10 years. But not much. Not nearly as much as what would be needed to justify the risk of investing heavily in stocks at today’s prices.
I am invested in TIPS and IBonds paying 3.5 percent real. Before the TIPS and IBonds were available at those rates, I had my money in certificates of deposit paying a real return greater than 3.5 percent real. From January 1998 forward, I am ahead of the game as a result of my decision to get out of stocks. That’s not supposed to happen. It’s not supposed to be possible for cash to outperform stocks for close to 10 years.
It happened. It becomes possible when stock prices get as wildly out-of-control as we saw them get in the late 1990s. I am ahead of the gamebefore we have experienced the worst of the price drop. Can you imagine how far ahead I will be afterwards? Can you imagine how much farther I will be ahead when I am able to invest in stocks at times of reasonable prices and enjoy the mouth-watering long-term returns that have always followed from doing so? Can you imagine how much farther still I wil be ahead after experiencing years of compounding on those outsized gains? Yes, price matters when buying stocks just as it matters when buying any other asset available for sale on this magnificent planet of ours.
I report to you my personal success with Valuation-Informed Indexing not with the intent to brag. I report to you my personal success with Valuation-Informed Indexing with the purpose of showing that cash is king not just in some theoretical world, but in the real world where real investors make decisions that determine how long it will take them to attain financial freedom. Valuation-Informed Indexing works. Common-sense investing works. Using the historical data to develop realistic long-term strategies works.
Cash is king today because there was a long period of time in which stocks were king. The money to pay the absurd returns paid to stock investors of the late 1990s was borrowed from those invested heavily in stocks today. I don’t feel any great desire to pay the bill for the party held by the investors of the 1990s. I invest to benefit me and I keep the realities of today in mind when doing so. That’s the only way to invest that makes sense.
Cash is king because investing in cash is what makes sense.
For now.