The Risk of Purchasing Power Loss

Great chart here from Josh Brown today showing the real after-tax return from cash relative to other asset classes (see figure 1).  It stresses how important it is to understand the role of cash in a portfolio and how damaging it can be to hold excessive cash levels at all times.

One of the things I am trying to achieve with Orcam’s Portfolio Reviews is to communicate the concept of a “savings portfolio”.  That is, most of us are not true “investors” in a secondary market (like a stock market) in the same sense that a private equity firm is when they actually front the money to help an operation grow.  Most of us are just exchanging shares of stocks or bonds on a secondary market and the corporation actually has no involvement in any of this.  So we’re not actually investing in Apple when we buy shares of AAPL on the exchange.  We’re literally exchanging cash for stock with another PERSON and not the company.   In other words, you’re simply allocating your savings.

Why does that matter?  Well, “investing” is often synonymous with high returns and high risks.  True investors like private equity firms who invest with start-ups and actually seed capital are generally engaging in a form of asset allocation that is substantially more risky than what we do when we buy shares of GE on the stock exchanges.  Most of us spend our lives making real investments in ourselves.  We spend huge amounts of time and resources becoming educated and working on perfecting a craft.  And what we save from our primary source of income should be allocated in a highly prudent manner.  This doesn’t mean we should never “invest”.  It just means we have to stop looking at our portfolios as though they’re a fragment of our lives and begin to think of the broader role that a savings portfolio plays in our lives.

And when you recognize that your repository of income is literally your savings portfolio we realize that most of us shouldn’t be piling 100% of our savings into some fancy sounding strategy or assuming that we’re “diversified” by owning stocks alone.  No, we should take a more all-encompassing view of our overall life portfolio and understand that our portfolios are a repository for our savings that need to grow, but also be protected.

The real goal for your life portfolio is to maximize the return from your real investments (like your primary form of work) and take the savings repository and allocate it in a manner that helps you protect against two primary risks:

1)  The risk of purchasing power loss.

2)  The risk of permanent loss.

You should construct portfolios that generate a moderately high risk adjusted return that protects you from these two risks.  You don’t need to “beat the market”.  In fact, it’s inappropriate for almost all of us to own 100% equity portfolios unless you’re willing to expose your savings to that rollercoaster ride.  We’re not competing with the S&P 500.  We’re competing against inflation and the risk of permanent loss.  Personally, I’d rather grind it out at work all day and know that the savings I generate from that primary income source is not creating even more stress and uncertainty in my life.  That’s the essence of the savings portfolio concept.

Cash_JB

Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services. He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.

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Comments

  1. So, how do we construct that kind of portfolio? Aren’t you leaving out the most important part?

      • DanH, you want to have a mix of stocks and bonds which historically have tended to move in opposite directions in the short to medium term. You get less volatility when you have a diversified portfolio with at least a small allocation to safety haven assets to which people run when the economy turns bad. This offsets to some degree a sharp downturn in stocks.

    • I hate the idea of passive vs active. I think it misses the point. There is no such thing as passive investing. There is only active investing and varying levels of active investing. Of course, I wouldn’t call most of what we do “investing”, but whatever. The point is, we are all active to SOME degree. If you dollar cost average, reallocate or reinvest then you’re active to some degree. Some others are more active in that they trade or something like that. So there are only varying levels of active asset allocation. I tend to think that high levels of active asset allocation creates frictions that reduce returns. But that doesn’t mean all active asset allocation is bad. There can be value in active asset allocation. Trouble is, most of us won’t find it in strategies that can be easily replicated by an index fund and that’s where most of us allocate money to….

      • The last point you make here is really important – savings allocators should worry a lot less about “which active manager am I going to select” and a lot more about “what is the right mix of investment strategies to help me meet my objectives”.

        The latter involves a much deeper consideration of portfolios than “let’s use the S&P 500 or the Russell 2000 as an index and get on with the real job of hiring managers to beat that index”.

        Apart from the fact that a large percentage of traditional active managers don’t beat the index (and even fewer do it after ajusting for fees, taxes and risks) your total performance is dominated by the index performance anyway.

        So work out what investment strategies you like – including if you want to turn that job over to a manager – and then think about someone to actually implement that investment strategy.

  2. Although it is very damaging to hold no-yield cash for a long period of time, during the past month and especially today, cash would have been a great place to be. I wish I had cashed in more than I did before today’s Fed announcement.

  3. Cullen, The FED has driven most investments ” higher than they would normally be” with QE. Doesn’t the potential loss of capital overwhelm the loss of purchasing power in today’s environment. Would one not be wise to stay in cash and wait for a lower entry point in the market. It seems to me that the distortions in the today’s stock and bond markets make it very likely that a permanent loss will occur unless one has an very long time horizon. Thanks again for the website and all the insight you and others offer here.

  4. Beating inflation and avoiding permanant loss is the goal of every single money manager or investor. Except for calling ‘investments’ savings — a nice way to focus the concept and separate yourself from other advisors — this is pretty much boilerplate, compliance approved copy for any money manager.
    For people who can stomach market risk, holding an S&P 500 fund will do the job and generate much, much greater returns for the saver and his or her heirs. You don’t want to put your short-term money there (which I will define as 10 years), but any money that you won’t need for 10 years should be in stocks (unless you are market timing.)

    • You missed the whole point of the article, which is par for the course for you.

    • It’s 100% bs that most advisors don’t pretend they can beat the market or justify their higher fees in other ways.

      Let me guess – you’re a BS advisor charging high fees with no value add, right?

    • “any money that you won’t need for 10 years should be in stocks”.

      That’s a dangerously simplified view of things in my opinion.

      And no, most advisors don’t view all of this the same way I do using the same macro approach I use. Most advisors don’t even run risk adjusted returns for their clients (something you conveniently left out of the goals) and that’s probably the most important piece of the puzzle. Show me an advisor who can run a Sortino Ratio calculation and I’ll show you 100 who can’t. If you don’t even understand basic benchmarking then you’re probably not adding much value. Sorry to be blunt.

      Also, I work as a totally independent fee only consultant. I am not a custodian. I don’t work for a bank. I don’t sell funds from my firm. I don’t charge recurring fees. I don’t sell nonsense about “beating the market”. In fact, I spend most of my time auditing guys who do what you do and telling clients why the advisor isn’t doing it right.

      If that’s a “biolerplate” approach to the industry then I am afraid you don’t really understand the way the industry is structured….My business model is a fringe operation with a style that very few advisors actually use….You can try to claim it’s not unique and that’s fine, but I don’t think that’s very accurate.

      • I might be wrong, but I view your work as an all encompassing view of the world that starts with a macro view and builds down. You can’t understand the investment approach if you don’t also understand MR and your world view entirely.

        I agree with JE that there are components of this that are pretty biolerplate, but the view as a whole is pretty refreshing and originally put together.

      • ‘Managing risk’ is the new buzzword in the industry. I’m not mocking the concept, because it’s been around forever, and all of us understand the idea at a gut level and most people practise it.
        Macro-based investing is also the dominant model at this time. There are very few bottom-up, value managers out there — although there are plenty of those who say they are. I don’t think very many money managers are out there visiting companies and talking to suppliers.
        Using the Sortino ratio makes sense. Modern portfolio theory treats upside volatality the same as downside volatility, which was silly, so using tools that capture downard risk makes sense. A man named James Breech manages money using this concept.
        The problem with using some of these concepts is that most investors don’t trust the advice. After all, they were sold MPT for years and that didn’t work, so they’re skeptical.
        It’s one of the reasons Warren Buffet is so popular — his methods *seem* pretty clear to the typical investor. It’s also why buy and hold works for those who can practice it, and many people can. Some can’t, and those were identified in 2008-09.
        What I’m interested in are conventional wisdom ideas that really do work, because, frankly, those are ideas that investors will practice.

  5. Cash was the asset that suffered the LEAST purchasing power loss in today’s market!

  6. Please explain why the last two columns on the right show a diference. I don’t understand where the tax on cash comes from?

    • I am guessing “cash” means everything from CD’s, money markets, and interest bearing savings and checking accounts….the interest of which should all be declared as income and is therefore taxed.

  7. I generally agree, but with one little nuance.

    The analysis above looks at ‘cash’ as yet another “asset class”. This is typical given the mindset of a strategic asset allocator. However, cash as another function and interpretation in a portfolio insurance framework: a store of optionality. In such context cash is viewed as a temporary tool to accumulate the optionality to buy assets at some appropriate moment. It is not viewed as an ‘asset’ to be held for a long period of time. Granted, the ‘optionality’ feature of cash comes with a cost of carry related to the loss of real value (except in brief deflationary peaks). There are times, admittedly not many, when holding a sizeable portion of cash makes sense given its higher than normal optionality value. Right now is a good example.

      • ….and entirely consistent with that idea of “strategic optionality” holding cash in the long run will cost savings allocators in real terms, just as if they had spend money on options premiums in financial markets.

        The value of cash as a strategic option can be very high, including the use of a negative cash position for those with the resources and stomach (although too many people who use gearing end up over-gearing because they gear for average and not extreme times).

        Holding cash is also a lot easier when you are being paid for your troubles rather than being paid nothing – think the 5% p.a. that Australian investors were being paid until recently comapred to the near-zero rates in the US, Japan etc.

        • Precisely. It’s not about active vs passive. There’s really no such thing since we’re all active. It’s really about allocating your savings using the strategies that best combine diversification, friction efficiency and planning in the achievement of whatever your goals are. Very active high fee managers could be totally appropriate (though they’re usually not), but proper portfolio construction and management is much more complex than 60/40 with a few funds. Of course, that looks smart given the recency bias of the last 20 years, but that’s convenient rear view mirror thinking….

  8. I dislike this type of chart. OK, yes, I promise not too hold too much cash for the next 76 years. But I have no problem holding cash for the next year or 3 years or 5 years until valuations improve. Too many talk about after-inflation cash returns yet seem to forget about after-inflation returns of stocks during secular bear markets.

  9. I think cash is pretty underrated. It is an explicit policy tool of the Fed. So when the Fed wants to slow down the economy by raising rates; cash benefits from this. There are times that the Fed engages to this policy to a level where no asset class is attractive, except cash.

    Personally, I think a portfolio of stocks, bonds, cash, and commodities (or just gold) gets you 90% of the way there. Most people are simply too greedy or think they are too smart for that level of diversification though. I think being an intelligent asset allocator requires a level of humility, and ironically finance tends to attract a large number of cocky people.