Cash -- Not as Safe as It Seems
Holders of cash and its equivalents (CDs, T-bills, and the like) may not
earn much in the way of interest, but they are at least certain to get all
of their principal back. For this reason, many people assume that holding
all cash is the safest and most conservative possible investment stance.
But there is a hidden threat to cash holders: while they are assured of
getting all their money back, the money they get may be worth less than it
was when they first deposited it. This is what's known as "purchasing power
risk."
We believe purchasing power risk to be a serious issue for today's cautious
investors. Our concern is owed to a strongly-held belief that the value of
the US dollar is likely to decline substantially in the not-too-distant future.
This is a topic that we will revisit in far greater detail down the road,
but for now we offer this brief synopsis of our reasoning:
1. Many of our trading partners are purposefully boosting the value of the
dollar in order to strengthen export-sector employment. At some point, the
political benefits to this policy will be outweighed by the costs, at which
time the artificial dollar support will gradually be removed.
2. As the deteriorating housing market begins to affect the general economy,
federal policymakers will respond in the usual manner: the Federal Reserve
will lower interest rates and the government will step up stimulatory deficit
spending. Both policies will result in more debt, higher inflation, and a
weaker dollar.
3. We as a nation owe a staggering amount of debt to foreign lenders, all
of it denominated in US dollars. Policymakers are almost assured to encourage
a decline in the dollar in order to lessen the real burden of our foreign
debt.
These macroeconomic forces will exert enormous pressure on the US dollar
in the years ahead. As a result, the interest earned by holders of cash-equivalents
is unlikely to compensate them for the eventual loss of the dollar's purchasing
power.
So what's a conservative saver to do?
The best way to mitigate purchasing power risk is to invest a portion of
your money into instruments that will keep their real value, or better yet
increase in value, should the dollar lose purchasing power.
There are a few categories of investments that fit the bill. Generally speaking,
buying stocks at good values provides decent inflation protection, because
over time, the stocks' earnings should grow to offset a decline in the currency
in which those earnings are denominated. However, it is important to buy
into companies that are not only reasonably priced but that will do well
in the coming economic climate (unlike, for instance, many US financial companies
that seem cheap but have unacceptably high exposure to the mortgage lending
business).
Foreign stocks are especially appealing, both because it's easier to find
good values worldwide and because owning foreign companies provides another
layer of protection against a dollar decline.
Then there are more direct hedges against a dollar decline. Foreign bonds
will rise in value as the dollar declines and will pay interest while you
wait. But because it's likely that other currencies will decline along with
the dollar, it's also advisable to invest in hard assets, such as precious
metals or commodities, or in the companies that produce them.
Many of these investments could be extremely profitable in the face of declining
US dollar purchasing power, but could still be expected to do reasonably
well even if the dollar decline took longer or was of a lesser degree than
expected.
Our advice to those whose main goal is to keep their money safe is this:
keep a healthy share of your holdings in cash-equivalents, but also put aside
a portion to invest in a diversified portfolio of the dollar-hedging investments
described above. The cash share of your holdings will provide you with liquidity
and stability of principal, while the investment portion should rise enough
to offset any loss of overall purchasing power.
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