Friday Finance: cash and gold

This is an extract from The Poor Man’s Guide to Financial Freedom: A Realistic, 10-Step Manual for Building Liberating Wealth on a Low to Medium Income.

Investment Categories

There are different investment categories.  Some, like cash and bonds, are better for short-term investment because they are more stable but they generally have a lower rate of return.  These are called ‘defensive investments’, i.e. they defend your wealth against the vagaries of fortune.  Shares and equivalents are better for long-term investment because, while volatile, they offer higher potential (not guaranteed!) returns and you will have time to recover from losses.  These are called ‘growth investments’ because they can increase, and not just preserve, your wealth.  You will probably need a mix of both defensive and growth investments. 

Defensive Assets 1 – Cash and Equivalents

Cash

Executive summary

Jargon: cash can include the physical notes and coins in your wallet, money in savings accounts, time deposits (also called ‘term deposits’ in Australia, ‘CDs’ in the US, ‘GICs’ in Canada and probably other names elsewhere), money market accounts (MMA)/high interest accounts and money market funds.  All of these are in the glossary. 

Risk: low.  You won’t lose any money unless the bank closes down, which rarely happens.  The government often underwrites deposits anyway.  Inflation will eat away your money over time though, as we discussed in ‘Future Dollars’.  A dollar today does not buy what it did twenty years ago, and will buy even less twenty years hence.

Return: low, especially at the time of writing.  Returns range from very close to 0% for a normal savings account up to maybe 3% for a long-term time deposit.  At other times interest rates for cash have gone up to 6%, but that usually doesn’t last for long.

The details

Cash is a store of value, not a productive asset.  That is, it doesn’t actually create wealth.  If you keep a few dollar bills in your wallet, they will not breed and create more dollar bills.

Cash tends to be the most stable form of investment so long as there is not hyperinflation.  Cash is ‘liquid’ in the sense that you can easily get at it if you need it at short notice, except for time deposits.  You were supposed to put your emergency fund into an easily accessible cash account back in Step 3.  You did that, right?

While quite safe, an ordinary bank account offers a low rate of return.  Remember inflation?  If it’s higher than your interest rate then you are actually losing money.  For example, if inflation is running at 3% and your bank savings earn only 2% interest, you’re losing 1% per year.  And many bank accounts don’t even offer that much of a return.

A time deposit (also called a CD or term deposit) is a cash investment for a fixed period of time, often six months or a year, that will offer a somewhat higher rate of return but you can’t easily withdraw your money.  This is a very safe investment but is not suitable for your emergency fund because you might need that money at a moment’s notice.  If you withdraw from a time deposit before the specified time period is up, you generally lose all the interest for that whole period.  Only put money here if you are sure you won’t need it in the meantime.  It is a good place to put savings for short-terms goals, i.e. Christmas expenses or a new refrigerator.

A money market account/high interest bank account can often be drawn upon at short notice but still doesn’t offer very high returns (at the moment).  You’d be lucky to find one paying much over 2% interest.  Most people either put their emergency fund here or in a money market fund.

You need some cash but it’s no good for the bulk of your long-term savings because the returns are too low and inflation will eat into it over time.  Most people keep no more than their emergency fund or around 10% of their total wealth in cash, depending on their individual circumstances.

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Bank Runs

Banks make money by taking deposits and lending money out to others at interest.  These days they can lend newly-created money but let’s leave that for now.

According to the rules of fractional reserve banking, banks only need to keep a small portion of their funds in ready cash, because usually only a fraction of their customers will want their money at any given time.

If customers suspect that their bank might not be able to pay out this money, either through real or rumored insolvency, then they are likely to rush to ATMs or bank tellers to get their money out before the bank collapses.  In such a case the first in line get their money, and if the situation does not come under control the bank will collapse and customers who arrive too late will miss out.  This is called a ‘bank run’.

A bank run can be brought under control if the panic is quelled, if the government bails them out (or promises to, which might be enough to calm nervous customers), or if another institution buys them out.

Bank runs are rare in developed countries but still occur sometimes in Third World nations.

Putting your money in a bank is probably the safest place for it – much safer than under your mattress – but nothing in this world is perfectly safe.

Different Currencies

Currencies can change their value relative to each other.  Over the last decade I’ve seen the Australian dollar go from about USD$1.10 to $0.59.  Some people hedge for this by holding their cash in more than one currency, especially if they are worried about the stability of their own currency.  For example, lots of Argentinians hold some US dollars.  This is reasonable if you live in a country with an unreliable currency or you travel a lot.  Larger banks usually offer foreign-currency accounts.

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Currency Speculation

There are some shysters who will try to sell you programs where you make short-term, speculative trades on currencies.  This is hard to do if you are not a professional, is very risky and goes against the whole point of cash as a safe, stable hedge against riskier investments.  Holding multiple currencies, just in case?  Fine, if it suits your circumstances.  Short term trading?  It’s a scam.

Gold and Other Precious Metals

Executive summary

Jargon: Gold and other precious metals such as silver and platinum are sometimes used as an alternative to cash as these can also act as defensive assets.  There are different types of gold you can buy, including physical gold that you keep in a bank safe, gold held in your name in bullion that you do not have physical access to, gold exchange-traded products where you invest online in a fund that tracks the gold price, cryptocurrencies that claim to be pegged to the gold price (more about cryptos coming up soon), or you could invest in the shares of a gold-mining company . . . and then there are all those other precious metals, too. 

Risk: The whole idea of investing in gold is to minimize risk as much as possible.  Historically, gold holds its value pretty well.  It tends to stay strong even when the stock market and real estate are tanking, and it often does particularly well when there’s a high inflation rate, or a perceived risk of such inflation.  People who invest in gold usually hold only a little so that if everything else in their portfolio is going to pieces, at least the gold portion ought to hold up and perhaps even rise in value during troubled economic times.

That does not mean there is no risk to gold at all.  If you wear gold jewelry, someone might snatch it.  If you keep gold at home it might be burgled.  A bank safe ought to be fine, but if you choose to sell it, you will have to physically take it out of the bank and to a dealer.  Hopefully you will not get mugged on the way.

As for those other types of gold – bullion held in your name that you can’t actually touch, exchange-traded products etc., these are pretty low-risk in that it is hard for anyone to steal it from you.  As for the veracity of the product – where the gold is stored, whether storage can be outsourced to third parties, if such contracts require insurance, are factors you’d have to check for yourself.

There are some gold bugs who fear an end-of-times collapse where any gold you do not physically possess will be confiscated or go up in a puff of digital smoke once the power goes off.  Such people tend to buy gold sheets that can be torn off in little squares for post-apocalyptic trading in a Mad Max world, and they also invest in ammunition, tins of tuna, and bunkers on remote farms that have their own water source.  Maybe they’ll turn out to be right, but this book is not really for investors who are that pessimistic about the future.

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Return: Generally, the returns on gold are very low.  It is intended to hold its value, not to grow.  In times of high inflation or other trouble the price may soar, but in normal economic times it will languish while stocks rise so far that they disappear into the sky.  You should think of gold as a store of value, like cash – not as an investment that is likely to earn you a return.  For this reason, nobody except those doomsday preppers holds a high percentage of their wealth in gold.

Other precious metals like silver and platinum are similar but as these have more extensive industrial uses, their value might fall in an economic downturn as industrial demand for them is reduced.  Some people hold only gold for this reason, while some hold a basket of metals to distribute the risk.  Many investors hold no precious metals at all.

The details

Nothing makes you think ‘wealth’ like gold does.  Shiny, heavy gold.  We can understand why dragons want to guard piles of it in their lairs, despite never buying anything with it.  Outside of fantasy tales and cartoons, no one really keeps the bulk of their wealth in gold or other precious metals.  Let’s look at why Smaug might have been misguided in his investment decision.

The idea of gold is that it ought to hold its value because there is a finite amount of it on Earth.  You can’t print or electronically generate more of it like modern money, it does not depend on someone paying you back like a debt, and it does not require a company to turn a profit, like shares.  For this reason, some currencies used to be made from gold, or later they were backed by gold, i.e. you could get actual gold in return for your US dollars.  This was called the ‘gold standard’ – the policy aimed to limit a government’s temptation to print too much currency by demanding reserves of actual gold to back up every dollar.

These days there is not a single, major currency backed by gold.  For this reason, holding gold is primarily a hedge against money printing or other currency devaluations by irresponsible governments that might lead to hyperinflation, as we saw in Weimar Germany where people had to take wheelbarrow-loads of cash down the street to buy bread.

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This will end well.

There are plenty of websites pushing gold as the best investment because of the risks of all the others.  These websites, by a wild coincidence, will also have some sort of gold-backed product to sell you.  While it is possible there might be massive inflation and the gold bugs will be proven right, it is more likely that in the long run everything will be fine and that gold will fall behind productive investments, i.e. those that generate, rather than just hold, value.  That is why gold is here under Cash and Equivalents – it is not an investment as such, it is defensive.  Like cash, it is not productive in the way that a business you might own shares in is productive.  Two gold bars sitting in a vault, like banknotes, will not breed and create more gold bars.  They will sit there and hopefully be worth about the same when you decide to sell them, regardless of whatever else has been going on.

There are those who invest in physical gold outside the banking system because they fear governments might seize some of their cash or other wealth held in bank accounts, as happened in Cyprus,[i] or they might freeze bank accounts during some crisis or strictly limit the amount that can be withdrawn per day, as has happened in Argentina.[ii]  How likely this is depends on how reliable banking and governance is in your country . . . and that, we could argue about all day. 

If you’re really worried about it, fine, get some gold.  Make sure you put it in a safe and don’t go blabbing to everyone that you’ve got it.  For the average investor starting out, you probably don’t need any.

Cryptocurrencies

Tune in next Thursday to learn why crypos are in the ‘cash and equivalents’ category as well as their risks, benefits and legality throughout the Anglosphere.


[i] https://www.theguardian.com/world/2013/mar/25/cyprus-bailout-deal-eu-closes-bank

[ii] https://www.nytimes.com/2001/12/03/world/argentina-limits-withdrawals-as-banks-near-collapse.html

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