Cash Rules the Day
April 16, 2009
For the last 25 years we have heard the phrase: "Cash is Trash". Financial experts actually warned us about keeping too much money in bank accounts or in our brokerage firm cash accounts. Buy stocks and get rich was a simplified version of investment advice in the 1990s and 2000s. Now we hear not only that cash is not trash, but that it is smart to keep some of our money in cash accounts like money market accounts, savings accounts, and checking accounts. So why the change in philosophy? There are three main reasons that has created this perfect storm for holding money in cash:
(1) Volatile Markets
40% or 50% market swings are just not for everyone. Retirement accounts and college savings accounts, in particular, are investment areas where the tolerance for risk is now low for Americans who have witnessed that violent wealth-destroying market swings are possible. But present with violent market swings are also buying opportunities. Holding money in cash account can let investors buy stocks on their darkest days. A year ago we would have loved to buy heavyweights stocks like GE ($33), Apple Computer ($122), Exxon ($67), Citigroup ($4), Pfizer ($13), and Coca-Cola ($45) at such bargain prices. By keeping some money in cash, it is easier to take advantage of the market downturns.
(2) Rotten Economy
It's not pretty for the U.S. economy. Falling prices, high unemployment, and negative growth have kept the economy mired in the worst recession since World War II. The loss of jobs and wages, which is the biggest concern for many households, is not expected to reverse track until late 2009 or early 2010. The hardships facing many Americans has driven home the need to keep money in emergency savings accounts. The funds that could be needed for six months worth of mortgage payments, rent, groceries, or health care expenses should be kept in an interest-bearing FDIC-insured account in case of financial hardship. Hoping that in a time of need your family can rely on credit card advances or home equity loans is just not good enough. As has been proven in this recession and credit crunch, mortgage lenders and credit card companies are quick to contract lending lines when times are rough. There is no substitute for the good old-fashioned savings account from a bank if a rainy day comes.
(3) Prices Falling
Another great reason holding cash makes sense in today's financial world is that the purchasing power of cash is greater today than it has been in the recent past. Prices as measured by the Consumer Price Index (CPI) recorded a loss in March 2009 of 0.4%. While this is not a significant drop in prices, any signs of deflation increases the value of the money held in savings accounts. The reason why is simple: We can buy more things. Whether we are talking about diapers, jets, or groceries; falling prices make the money in our checking and savings accounts go further. It also helps out the investment returns from cash in bank accounts. For instance, a bank money market account earning 3% today with the CPI registering -.4% yields a real rate of return of 3.4%. Whereas a year ago a bank money market earning 5%, but with CPI registering 2.2% would yield a lower real rate of return of 2.8%. It may not feel like it, but deflation makes the 2% and 3% rates on money markets, CDs, and savings account pretty good.
