We shall start our look at the different asset classes this week.
I do not intend to go too deeply into many of the assets themselves. There are plenty of good definitions on the internet or in textbooks.
Rather, I want to look at the asset classes from an investing perspective.
How liquid are the assets? What are their risk and return profiles? What other factors impact their performance? How should you consider their suitability in your investment portfolio?
Today we will review Cash and Cash Equivalents (CCE).
Cash is king.
In life, all things material revolve around the almighty dollar. Without cash, you cannot purchase those things you need to survive.
So this is an important asset class.
What is CCE?
As an asset class, CCE covers real cash, such as what you have in your savings or chequing accounts, or even hidden under your mattress.
It also includes other assets that possess these characteristics:
1. Extremely liquid,
2. Provide known rates of return, where investment risk is (almost) zero, and
3. Risk of capital loss is negligible.
Examples include: short term government treasury bills; short term government bonds; short term commercial paper, acceptance paper, or banker’s acceptances from highly rated companies; bank term deposits and Guaranteed Investment Certificates (GIC); money market funds.
As an aside, I was a little hesitant to label this category Cash and Cash Equivalents. Some expert commentators like to include many marketable securities as cash equivalent. This is due to the high level of liquidity for fixed income and equities that trade on major exchanges. Also, that most individual investors lack the capacity to influence the asset price through their own holdings.
Where including fixed income or other assets in CCE breaks down is in the investment risk. Both in the expected returns and in the potential for capital loss. As we will see in due course, other asset classes all have higher risk levels that CCE.
Liquid assets can be quickly converted to cash; at minimal to no financial cost, nor impact on the asset price.
CCE are the most liquid of assets as they are already cash, or one small step from being cash.
In part due to the liquidity benefit, you should have your emergency funds primarily in CCE. This should amount to between 3-6 months’ cash requirements. As your general level of wealth increases, you can reduce the amount of liquidity held to some degree.
You should also invest in CCE with assets required for any short term spending requirements. The closer the time to the expenditure, the greater the need to keep the required funds in liquid assets.
For example, a house you plan to buy in 4 years. You could invest in a wide variety of assets, both liquid and illiquid. However, if you need to close the home purchase in only 4 months, you should have all the necessary funds invested in highly liquid investments.
Negligible Investment Risk
CCE are considered investments that have little, if any, investment risk.
That means the difference between the expected and actual rates of return is almost non-existent. There is no real volatility in the performance of this asset.
The Good News – Cash is Relatively Risk-Free
In investing, cash is considered certainty. With every other investment, there is some uncertainty that the amount you expect to receive in the future will be actually what you get.
If you recall our discussions on risk, the greater the uncertainty between what you expect to earn and what you actually earn is the risk (or volatility) of the investment.
With cash, there is no risk in the investment sense. What you have in your jeans is fully certain, assuming there are no holes in your pockets.
You know what you have and you can plan your spending accordingly.
Now there may be some investment risk with CCE, at least the CE portion of the term.
A GIC with a solid, national bank may have less risk than one with a small, regional institution which is having business difficulties. Although both GICs are considered cash equivalents, you need to look at the other risk factors also. We will look at this below.
The Bad News – Cash is Relatively Risk-Free
There is a direct relationship between risk and return.
The lower the risk of an investment, the lower the expected return.
So while CCE are risk-free to a great extent, the returns that you will earn will be low compared to other investments.
While this may protect you during the short term, when investing for long time horizons you should be considering higher risk assets, with better expected returns.
This is why many asset managers recommend only holding about 5-10% of one’s assets in CCE.
This amount typically covers the liquidity needs I mentioned above. It also serves as an investment reserve to allow for new purchases to be made without having to liquidate other non-cash assets.
Known Rates of Return
Time Value of Money
Knowing with certainty your actual return is useful when investing. When looking to the future, you can plan your investments to meet your upcoming cash requirements.
The higher the certainty, the better your planning can be.
You can invest that dollar today and receive more than that dollar tomorrow. Or next week or year. That is the basis for the time value of money principle.
In the case of CCE, your future return is almost certain.
For example, you need to pay $5150 for your school tuition and books in 6 months time. If you have $5000 now, you could invest in a 6 month Guaranteed Investment Certificate (GIC) from your bank paying 3% over the term. Upon maturity, you would receive your $5000 in capital, plus another $150 in interest income.
You have exactly enough to meet your requirements. Simple.
Now consider an investment in shares of Citigroup.
Over the 6 months, many variables could impact the share price. There is a possibility that the shares may be worth substantially more than the required $5150 in 6 months. But there is also a strong probability that the shares will be worth less than that amount. If the latter scenario occurs, you will not have enough money to fund your school needs.
So for short term requirements, focus on liquid assets with minimal investment risk.
Beware of Non-Investment Risk Factors
While the investment risk is negligible and the nominal return is known, other factors can greatly impact your real wealth accumulation.
Inflation can erode the future purchasing power of your money by making goods more expensive over time.
In our example, you require $5150 for tuition and books. However, during the 6 months before you pay, inflation rises 4%. The equally affects your school requirements. Now your total costs have risen to $5356.
Had you not considered the potential impact of inflation, you would not have saved enough money for the required costs.
In our example, you would have invested in the GIC and ended up with $5150, but that would be $206 short.
A second takeaway concerning inflation is that it can reduce real wealth. In our example, you invested your cash in a GIC. However, inflation outpaced the interest rate and your real wealth actually fell. As we discussed before, you need to always focus on real returns, not nominal ones.
If you live in a country whose currency is declining, you may also see an erosion of your cash value on a global scale.
Say you live in the US and want to buy a new BMW. Specifically one that is manufactured only in Germany. The car costs Euro 100,000 and the Euro/USD exchange rate is 1.00. Over the next 6 months you save your money and finally have USD 100,000 in the bank. You head down to the BMW dealer and go to place your order.
Unfortunately for you, while the price of the BMW is still Euro 100,000 that crazy US dollar has fallen to 0.80 against the Euro. In US dollars, your BMW now will cost you USD 125,000.
So while your liquidity and short term investing were not issues, you nevertheless suffered a shortfall due to the currency fluctuation.
As I wrote above, GICs are issued by different financial institutions. Some are financially more stable than others. The same holds true for many other financial instruments.
When reviewing investment options, do not assume that a term deposit, commercial paper, or even government treasury bill is entirely risk-free.
Always review the issuing entity and determine whether they are stable or not.
One way to quickly tell involves the returns being offered.
For example, banks A, B, and C all sell 1 year GICs. The GICs from both A and B offer 5% annual interest rates. Bank C offers 7%.
Exactly the same product, so why the difference is rates?
Remember that risk and return are directly correlated. The higher the risk, the higher the return.
If I analyzed bank C, I would expect to see that there is higher risk of non-payment for the interest or original capital as compared with bank A or B. Because of the increased risk, bank C must offer higher rates than A or B to induce investors to take on the higher risk. If C offered only a 5% return, no rational investor would purchased a GIC from them.
Conversely, if C was as secure a bank as A or B, yet offered higher interest rates, no investors would purchase GICs from either A or B. Those banks would need to increase their interest rates to be competitive.
For additional risks that may impact even liquid assets, please check this out.
So while CCEs may be relatively risk-free from an investment perspective, you need to be aware of other risks that can affect your cash’s value.
Next we shall look at fixed income as an asset class.