Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 446

Is there any point in holding cash?

With yields on cash-like assets barely above zero, it begs the question of whether cash has any role in a portfolio apart from for liquidity purposes. Shouldn’t cash be held at minimal levels given the lack of any meaningful return? Not so quick!

Cash offers a unique feature – capital protection. If you invest $1 in cash, you can expect to get your $1 back plus (a little) interest. Other assets do not offer this feature because their prices fluctuate. This positions cash as the asset that might help defend the portfolio if all other assets fall in price for some reason.

Here is a framework for thinking about cash and a plausible scenario under which a ubiquitous bear market in all assets would see cash provide a safe haven.

More complex than just getting your dollar back

Of course, the nominal value of capital is not all that matters. ‘Real’ (inflation-adjusted) purchasing power also needs to be considered. Real purchasing power will be eroded if cash rates run at less than the inflation rate but will be protected if cash rates match or exceed inflation.

Real cash rates are currently negative, with cash-like assets that yield much over 0.25% not to be found without taking some capital (i.e. credit) risk. Meanwhile, the latest CPI readings are running at 3.5% in Australia and 7.5% in the US over a year ago.

An important point is that cash rates continually reset. This means that the future path of rates (and inflation) are more important than where both stand today. If cash rates rise in response to inflation so that real rates remain positive over time, then cash will protect the real value of capital and provide an effective inflation hedge. If cash rates do not keep pace with inflation, then real capital will be eroded, although this tends occur as ‘capital death by a thousand cuts’ rather than large one-off losses. How central banks conduct monetary policy is pivotal.

Breaking down the drivers of asset prices

My framework is one where asset prices are determined as the present value of future expected cash flows by applying a discount rate that reflects the return required by the market. Under this framework, asset prices can fall for two reasons.

First is a decrease in expected cash flows. A stock suffering a sell-off after the market revises down its earnings is a classic example.

Second is an increase in the discount rate. The latter amounts to the asset repricing down to offer a higher return going forward.

Cash is unique in that it carries no meaningful cash flow or discount rate risk (assuming no default risk). It is a promise to give back your invested capital plus any interest. As a consequence, cash will be most valuable in circumstances where broad-based reductions in cash flows or increases in discount rates occur that hit all other assets. Meanwhile, cash carries reinvestment risk because its rate of return continually resets.

Broad-based decreases in cash flows across assets could occur in, say, a global recession. However, under such circumstances there are usually some assets that provide reliable cash flows that may help protect the portfolio.

Government bonds have traditionally played this diversifying role, often more effectively than cash as discount rates also tend to fall during recessions. At least they have over the last 30 years or so.

Where cash can really come into its own is during an across-the-board rise in discount rates that hits the prices of all assets. This is where the danger seems to lie today.

A scenario where all markets reprice

Yields near record lows (see charts) and many assets trading on high multiples are signs that discount rates are currently low. The risk is that this may not be sustainable. Higher inflation and tightening by central banks mean that discount rates could be going up, possibly considerably. This would be tantamount to markets going from being broadly priced for low returns repricing downwards so that they offer higher returns.

 

It is possible to imagine a scenario where central banks take cash rates to 3%-5%, government bond yields return to above 3%, multiples on equity-like assets shift to lower levels, property cap rates move to higher levels, and the housing market needs to adjust to mortgage rates back at 5%-6%.

You get the picture. Nearly everything reprices down as discount rates rise. Equities, bonds, property, etc. all get hit. Meanwhile, cash holds its value.

This may not matter so much if cash flows were increasing at the same time. Here consideration needs to be given to the influence of inflation, and central banks that seem to have placed themselves behind the curve. Monetary tightening to rein in inflation involves restraining growth – that is the point, in part. But there is a chance that the result is more than a slowing in growth. This could occur either because inflation proves so intransient that aggressive tightening is required, or central banks miscalculate.

Of course, a combination of rising discount rates without an offset from rising cash flows is just one possible scenario. But it seems a scenario that is not too far-fetched given current circumstances. Holding some cash can help protect the portfolio if such a scenario eventuates and diversification fails.

Two other things to consider

What happens to cash rates and inflation will determine the degree of capital protection provided. Will cash rates be returned to above inflation as central banks tighten, so that real capital is protected? Or will cash rates be maintained below inflation so that cash continues to erode real purchasing power thus diluting the benefit of the hedge?

It is a moot point how much tightening is required to rein in inflation, and how far central banks are willing to go once the impacts on the markets and economies begin to appear. In any event, focus should be on the future trajectory of cash rates relative to inflation, rather than where rates and inflation stand today.

Another issue is grappling with the market dynamics. The charts below illustrate what could happen if the market continues on while you sit in cash, versus the scenario where cash is redeployed back into a market adjustment at a higher rate of return. But market timing is far from easy. If you shift to cash too early, and the market continues onwards only to correct from higher levels, there might be no net benefit.

Further, redeploying excess cash back into the markets once the adjustment occurs is tricky to execute. The benefit of the hedge would be much diluted, or even nullified, if cash is redeployed either too early and markets continue to fall, or too late so you miss the recovery. For some investors, staying the course but bracing for a possible hit might be a sensible approach.

 

In summary, cash is a defensive asset with unique attributes

My key message is that cash should be seen as a defensive asset with unique attributes that are valuable in certain situations, specifically when discount rates rise and prices fall across all assets. It at least protects the (nominal) value of capital and could also protect the real value of capital if central banks manage towards positive real rates in due course (no guarantees here).

Cash is better considered from this perspective and not treated as trash simply because cash rates are currently extremely low.

 

Geoff Warren is an Associate Professor at the Australian National University. He has also had an investment career spanning asset consulting, portfolio management, investment strategy and equity research; and currently sits on a number of investment-related advisory boards.

 

5 Comments
C
February 22, 2022

The potential loss from market crash is likely to be a lot more than inflation-induced loss of purchasing power.

Ruth
February 20, 2022

The RBA can't raise rates too high or the currency will be too strong for our export markets, which are underpinning the GDP of our economy.

Jeff O
February 19, 2022

RBA???....a lot more savers ??? do you mean all households?? the distribution?? - retirees v renters v single parents...what about business ??government savings ?? country as a whole ? yes - a sustained current account surplus for now the future ??? RBA's goals are full employment....financial stability..... little to do directly with savers or borrowers ....rather (national) savings and long term growth/income/wealth....and RBA policy mainly a cyclical tool except in a crisis fortunately, looks like QE over and policy rates will "normalise" we now need to focus on the medium to long term and, the real issues lay with structural reforms....and a lot depends on government policies apart from other secular influences on productivity (such as ageing etc etc)...and the national interest...and our grandchildren

George
February 17, 2022

The RBA focus on cash as low as possible allowed the residential property market to surge 25% last year when Lowe should have been ahead of controlling inflation. But the other side not discussed is the RBA punished retirees trying to protect capital by holding cash. If they had reduced the cash rate to 1% instead of 0.1%, it would have taken the top off house prices to everyone's benefit, and at least given something for retirees. The RBA has a lot to answer for in its slow inflation response and it is already regretting saying no increases until 2024 when cash will obviously rise in 2022. And about time. There are a lot more savers than borrowers in the economy.

SMSF Trustee
February 20, 2022

Sorry George, but this particular retiree (or nearly so) hasn't been hurt by low cash rates because I still hold mostly shares and property. Where the idea that retirees have to own zero volatility assets that pay interest to live on came from is beyond me!

 

Leave a Comment:

RELATED ARTICLES

Rising real yields likely to undermine equity values

The bank is still a terrible place to put your money

Trusting the process in a high-rate environment

banner

Most viewed in recent weeks

Australian house prices close in on world record

Sydney is set to become the world’s most expensive city for housing over the next 12 months, a new report shows. Our other major cities aren’t far behind unless there are major changes to improve housing affordability.

The case for the $3 million super tax

The Government's proposed tax has copped a lot of flack though I think it's a reasonable approach to improve the long-term sustainability of superannuation and the retirement income system. Here’s why.

Tariffs are a smokescreen to Trump's real endgame

Behind market volatility and tariff threats lies a deeper strategy. Trump’s real goal isn’t trade reform but managing America's massive debts, preserving bond market confidence, and preparing for potential QE.

The super tax and the defined benefits scandal

Australia's superannuation inequities date back to poor decisions made by Parliament two decades ago. If super for the wealthy needs resetting, so too does the defined benefits schemes for our public servants.

Meg on SMSFs: Withdrawing assets ahead of the $3m super tax

The super tax has caused an almighty scuffle, but for SMSFs impacted by the proposed tax, a big question remains: what should they do now? Here are ideas for those wanting to withdraw money from their SMSF.

Getting rich vs staying rich

Strategies to get rich versus stay rich are markedly different. Here is a look at the five main ways to get rich, including through work, business, investing and luck, as well as those that preserve wealth.

Latest Updates

SMSF strategies

Meg on SMSFs: Withdrawing assets ahead of the $3m super tax

The super tax has caused an almighty scuffle, but for SMSFs impacted by the proposed tax, a big question remains: what should they do now? Here are ideas for those wanting to withdraw money from their SMSF.

Superannuation

The huge cost of super tax concessions

The current net annual cost of superannuation tax subsidies is around $40 billion, growing to more than $110 billion by 2060. These subsidies have always been bad policy, representing a waste of taxpayers' money.

Planning

How to avoid inheritance fights

Inspired by the papal conclave, this explores how families can avoid post-death drama through honest conversations, better planning, and trial runs - so there are no surprises when it really matters.

Superannuation

Super contribution splitting

Super contribution splitting allows couples to divide before-tax contributions to super between spouses, maximizing savings. It’s not for everyone, but in the right circumstances, it can be a smart strategy worth exploring.

Economy

Trump vs Powell: Who will blink first?

The US economy faces an unprecedented clash in leadership styles, but the President and Fed Chair could both take a lesson from the other. Not least because the fiscal and monetary authorities need to work together.

Gold

Credit cuts, rising risks, and the case for gold

Shares trade at steep valuations despite higher risks of a recession. Amid doubts that a 60/40 portfolio can still provide enough protection through times of market stress, gold's record shines bright.

Investment strategies

Buffett acolyte warns passive investors of mediocre future returns

While Chris Bloomstan doesn't have the track record of his hero, it's impressive nonetheless. And he's recently warned that today has uncanny resemblances to the 1990s tech bubble and US returns are likely to be disappointing.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.