Cash - The Benefits And Risks
CASH- The benefits and risks
Who can benefit?
Every investor who wishes to have an understanding of a primary asset class.
What is it?
Cash is generally referred to as money at call. That is, you may access your funds quickly. Such funds are held in savings and cheque accounts through banks and other financial institutuions. The definition of cash also generally includes fixed term investments of less than one year. This would include some term deposits and bank bills. The basic attributes of cash is that it pays a predetermined rate of interest, the capital is stable and is liquid or near liquid. Term deposits may often be cashed in advance of the maturity date with the payment of penalty interest.
What are the benefits?
Cash is considered to be a "safe" investment, although how safe it is depends on the credit worthiness of the institution of where it is held. Depending on the country, bank deposits are not generally guaranteed by the government and there have been recent examples of cash investments being lost.
Otherwise, the capital does not fluctuate in value, as do other asset classes. The return can fluctuate and generally moves up or down in relation to the rates set by the central bank, or in America, the Federal Reserve.
Cash is necessary to fund your immediate and short-term expenditure. It is essential to match your investments with your expenditure requirements. Although growth assets such as property and shares have higher returns in the long-term you would not fund the purchase of a new car in six months' time by investing in shares today.
Cash is the ideal medium to store funds while you are waiting for a long-term investment opportunity to appear. For example, you may hold cash if you are expecting a rise in interest rates before investing in long-term bonds.
Any downside?
Cash may appear to be a low risk investment however it may be very risky in that your investment and lifestyle objectives may not be realized. The long-term return of cash is only slightly higher than inflation (Consumer Price Index) and after taking into account your marginal tax rate, the return may be less than inflation.
Therefore cash is a poor hedge against the loss of purchasing power through inflation. Most people require some growth in their investments to reach their goals and this can only be achieved by investing some funds in shares and property as well as cash and fixed interest. Nevertheless, cash does help to smooth out the returns in a balanced portfolio.
It is very important to understand the concept of inflation to appreciate how the low return of a cash based investment can seriously impact on your lifestyle in the long-term. This is best show by the "rule of 72".
The "rule of 72" is a simple calculation of how long prices will double if you know the long term inflation rate. You simply divide the inflation rate into 72. For example, if inflation is 5% then prices will double every 14.4 years (72/5).
The "rule of 72' also shows how long it will take for your investment to double given a long- term investment return. For example, if the after tax return of your cash investment is 3% then your investment will not double in value for 24 years (72/3).
Clearly with the examples shown a low yielding cash investment can rapidly fall in real value if the after tax return is not at least as great as inflation. The scenario is even worse if you must take capital out to fund your cost of living.
Who can benefit?
Every investor who wishes to have an understanding of a primary asset class.
What is it?
Cash is generally referred to as money at call. That is, you may access your funds quickly. Such funds are held in savings and cheque accounts through banks and other financial institutuions. The definition of cash also generally includes fixed term investments of less than one year. This would include some term deposits and bank bills. The basic attributes of cash is that it pays a predetermined rate of interest, the capital is stable and is liquid or near liquid. Term deposits may often be cashed in advance of the maturity date with the payment of penalty interest.
What are the benefits?
Cash is considered to be a "safe" investment, although how safe it is depends on the credit worthiness of the institution of where it is held. Depending on the country, bank deposits are not generally guaranteed by the government and there have been recent examples of cash investments being lost.
Otherwise, the capital does not fluctuate in value, as do other asset classes. The return can fluctuate and generally moves up or down in relation to the rates set by the central bank, or in America, the Federal Reserve.
Cash is necessary to fund your immediate and short-term expenditure. It is essential to match your investments with your expenditure requirements. Although growth assets such as property and shares have higher returns in the long-term you would not fund the purchase of a new car in six months' time by investing in shares today.
Cash is the ideal medium to store funds while you are waiting for a long-term investment opportunity to appear. For example, you may hold cash if you are expecting a rise in interest rates before investing in long-term bonds.
Any downside?
Cash may appear to be a low risk investment however it may be very risky in that your investment and lifestyle objectives may not be realized. The long-term return of cash is only slightly higher than inflation (Consumer Price Index) and after taking into account your marginal tax rate, the return may be less than inflation.
Therefore cash is a poor hedge against the loss of purchasing power through inflation. Most people require some growth in their investments to reach their goals and this can only be achieved by investing some funds in shares and property as well as cash and fixed interest. Nevertheless, cash does help to smooth out the returns in a balanced portfolio.
It is very important to understand the concept of inflation to appreciate how the low return of a cash based investment can seriously impact on your lifestyle in the long-term. This is best show by the "rule of 72".
The "rule of 72" is a simple calculation of how long prices will double if you know the long term inflation rate. You simply divide the inflation rate into 72. For example, if inflation is 5% then prices will double every 14.4 years (72/5).
The "rule of 72' also shows how long it will take for your investment to double given a long- term investment return. For example, if the after tax return of your cash investment is 3% then your investment will not double in value for 24 years (72/3).
Clearly with the examples shown a low yielding cash investment can rapidly fall in real value if the after tax return is not at least as great as inflation. The scenario is even worse if you must take capital out to fund your cost of living.
This is an amended excerpt from Financial Planning A to Z, to be published in late 2012. Refer my website www.barrylizmore.com.au for more details. Articles of a similar nature will be posted at the start of each week.
Article Source: http://EzineArticles.com/?expert=Barry_D_Lizmore
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