How To Avoid The Cash Crash

Shares may be volatile, but for the long term investor, they are certainly far lower risk than cash, and offer far better returns!

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It's undeniable; the market has crashed.

But I'm not talking about the stock market — that's been hovering near record all times highs for some time now. And it's not property, which has also been on an incredible tear.

I'm talking about the market for cold, hard cash. And the irony is, this is the asset that we're told is the safest investment available! Of course, when you put your money in the bank, you know it will be there next time you look. You'll even earn interest on it. But that doesn't make it a safe asset for long term investors — far from it.

Think about it.

The value of cash has only ever deteriorated over time. What you could buy for $1 five years ago, now costs — on average — about $1.13 today. And unlike most investments, the drop in value only gets worse over time.

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If you had stuffed $10,000 under the mattress in 1990, you would find that today it only buys about half of what it used to. Inflation really is a silent killer for long term investors, and cash is the worst place to be.

Of course, few people would consider stuffing cash in a mattress a sensible investment. If you instead deposit that money in a savings account, or buy a term deposit, you will of course earn interest. And generally speaking, the interest we Australians have been able to earn in the past has meant that we've been able to stay a little ahead of inflation.

The trouble is, the earning power of our cash has well and truly crashed.

Consider the official Reserve Bank Target Cash Rate, which is the interest rate it charges banks and is what largely determines the interest rates that banks pay us (with a modest margin, naturally). Despite the occasional uptick, that rate has been in steady decline for 26 years.

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The crash in interest rates is enough to make a stock market meltdown look tame! Even the worst stock market crashes tend to recover in time, but the 'bear market' in interest rates has been going strong for over a quarter of a century! And, with the majority of economists expecting the RBA to further cut rates this year, it seems the 'cash crash' is far from over.

Interest rates are near the point where we can no longer be confident that they will help us outpace inflation. With the RBA's target cash rate now below the 5-year average inflation rate, an investment is cash is very likely to yield negative real returns!

Still think cash is a safe investment?

It's certainly the best place for your money if you are looking to spend it in the next few years — after all, cash isn't volatile like shares or property. But given the purchasing power of cash is continually being eroded by inflation, and because the return it now generates is even too low to comfortably account for inflation, it is without doubt the worst place for your money long term. Period.

That's why shares are a far better bet for long term investors. Unlike cash, shares tend to rise in value over time. As does the amount of dividends they pay.

Sure, share prices can jump all over the place in the short term. Sometimes, the entire market 'crashes', and when it does not all companies survive. And that can make share market investing seem risky, even dangerous! And so it is for those that gamble on short term share price movements, or who buy into speculative companies; they are playing with fire — and likely to get burnt!

But for the sensible investor, who buys a diversified range of quality businesses, and who invests for the long term, the risks are actually very modest. Certainly less than the risk that cash represents in the long term!

Why? Because unlike currency, which serves only as an 'intermediary to transaction' and store of wealth, shares represent productive enterprises. They make goods, they offer services and, ultimately, the generate value for their owners.

Good businesses, with real pricing power, are largely immune to the effects of inflation. Any increase in costs are passed onto the consumer through higher prices. Consider the major supermarkets — the money needed to produce a can of baked beans (say) may have gone up over the years, but these costs are passed straight onto shoppers. Margins are, for the most part, maintained as is profitability.

In fact, quality businesses tend to grow over time. As volumes rise, as they branch out into new products and services, and as they enter new geographies, they tend to gain valuable economies of scale. Which essentially means that their costs rise less than their sales.

And best of all, because they make more money than is needed to sustain and grow the business, they are able to share the excess profits with shareholders in the form of dividends. In many cases, the tax man will even give you a significant saving on this income.

For the service I run — Motley Fool Dividend Investor — we focus only on profitable, established companies. Companies with a capacity to generate attractive returns and a willingness to share these with shareholders. Companies that have real pricing power and strong competitive advantages. The kind of companies that will grow your capital over time, and generate a reliable, attractive and rising income stream.

With companies on our scorecard yielding over 4% on average — it's certainly alot better than what cash is offering and, unlike money in the bank, the value of your investment should actually increase over time.

Shares may be volatile, but for the long term investor, they are certainly far lower risk than cash, and offer far better returns!

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