Cash Has Been the Riskiest Investment

Here's a post courtesy of Marotta Asset Management.

If you think hiding money under your mattress is a risk-free way of building wealth, think again. Cash, it turns out, has been the riskiest investment since 2002. Many investors try to avoid risk by putting their money in a bank account or investing in CDs. But like any other investment, cash is subject to its own set of risks.

Cash is dangerous because the dollar can be devalued. When our currency decreases in value, we experience inflation and the purchasing power of the dollars we hold is compromised. Having the same amount of dollars doesn't do you any good if your dollars won't buy as much as they used to.

Since the beginning of 2002, the U.S. dollar has lost much of its purchasing power. From 2002-2007, the U.S. Dollar Index has dropped over 36% from 120 to 76.5. During that same period, the dollar has dropped over 39% against the Euro going from $0.88 to a Euro to $1.45. And the dollar has dropped over 64% against gold going from $280 to an ounce of gold to $795.

Money market's real risk is the dropping value of the dollar, not exposure to subprime lending. Cash in money market has lost over 40% of its buying power since 2002. And the US Dollar has dropped 10% just this year alone.

Interestingly enough, the consumer price index (CPI) over this same period has only registered a 15% drop in the dollar's purchasing power. While 15% is still significant, many economists believe that the federal government has been under reporting CPI since they changed the rules for computing it in 1996.

Purposefully under reporting CPI allows the government to cut the impact of cost of living increases in social programs and helps curb runaway government entitlement programs. Started under the Clinton administration and continued under Bush, these changes have rendered the official CPI numbers less meaningful.

Current CPI calculations have changed inflation numbers through tricks such as "substitutionary adjustments", "component removal" and "hedonic deprecators". This creative accounting rivals anything done by Enron. These changes were made specifically during a political debate over cutting back cost of living increases to Social security and other federal benefits. The changes have saved the Government tens of billions of dollars a year at the expense of benefit recipients whose benefits buy them much less now than they did a decade ago.

Any attentive consumer knows that cumulative price inflation since 2002 has been closer to 50% than 15%. This corresponds to the CPI being understated by about 5% a year. One study suggested that the CPI index has been understated by about 7% per year. No matter the exact amount, your bank deposits and money market funds have been the riskiest investments and have lost significant buying power to inflation. The danger of the U.S. dollar continuing to decline is aggravated if you try to be "safe" and over-expose your investments to cash and money market.

Just this year the dollar has continued its decline. Since the beginning of 2007, the U.S. Dollar Index has dropped 9% from 84.2 to 76.5. The dollar has dropped over 10% against the Euro going from $1.30 to a Euro to $1.45. And the dollar has dropped over 21% against gold going from $625 to an ounce of gold to $795.

Over half of your portfolio should be protected against the risk of a falling dollar. You can protect your portfolio against a falling dollar with investments in foreign bonds, foreign stocks, and hard asset stocks. Hard asset stocks are one of the best ways to protect yourself. As an asset class, they have also provided one of the best returns since 2002.

Hard asset investments include companies that own and produce an underlying natural resource. Examples of these natural resource stocks include companies that produce oil, natural gas, precious metals (particularly gold and silver), base metals such as copper and nickel, and other resources such as diamonds, coal, lumber, and even water.

Keep in mind that investing in hard asset stocks is not the same thing as investing directly in commodities. Buying gold bullion or a gold futures contract is an investment directly in raw commodities or their volatility. Commodities, as an asset class, generally maintain their buying power in dollar terms. Stocks, as an asset class, generally appreciate over inflation after dividends are factored in. For that reason, it may be to your benefit to invest in hard assets stocks which have an underlying commodity.

One index that tracks hard assets is the Goldman Sachs Natural Resources Index. This index is comprised of 70% energy and 11% materials. As of the end of October 2007, this index is up 34.00% year-to-date. Its three-year annualized return is 30.69% and its five-year annualized return is 30.43%.

And please don't be fooled into thinking that cash in your mattress is a safe investment.

Comments

[Early Retirement Extreme]

Clever of them to pick something close to a market bottom to prove their point. Now, if you pick the peak of the last market cycle in 2001 and compare to the peak of 2007, you would have done just as well in CDs compared to the Dow Jones Industrials. Of course very few things would have beaten commodities in the current commodity bull market. However, being fully invested in commodity stocks in the 1980-2000 run would have been less smart.

[Edmund]

The bottom of the last bear market happened in the July of 2002. The dollar also peaked in 2002. It has been steadily dropping since.

It's not the end of the world. I would say the dollar has been "overvalued" back then, and it is just returning to similar level seen in the 90s.

This article seems to plug investing in commodity. While I am all for diversification, buying gold is no different than putting money under your mattress. You are not getting any interest/dividend.

I just find it disturbing that this article is trying to make its point by selecting a specific period that happens to favor the point. It does not appear to be done in good faith if the period is favoring the point well above historical returns.

[Steve]

I'd just like to agree with the other comments and basically agree that this article is very sloppy.

Currency exchange rates are determined by supply and demand or the market. Inflation is but one factor that influences that supply and demand.

I wonder if the author of this article would say that the CPI calculations were overstating inflation from 1995 through 2002 when the dollar appreciated rapidly while inflation was still positive. If one were to follow the author's logic in this article, one would have to conclude that since gold has appreciated 0% since 1980 in dollar terms that there has been no inflation since then.

[Jake]

I have been reading this blog for several months now -- prehaps a year? This is probably the worst post, or at least the worst article, that I've seen on this blog in that time period. It is sloppy and worst of all misleading.

"Since the beginning of 2002, the U.S. dollar has lost much of its purchasing power. From 2002-2007, the U.S. Dollar Index has dropped over 36% from 120 to 76.5. "

True, but in an article primarily about inflation, it is incredibly misleading to quote a currency exchange rate index to prove a point. FMF, unless your readers have their savings in dollars and spend their money in Euros or Yen, this point is of peripheral importance and yet is extremely misleading about the magnitude of dollar movements and/or the alleged "high risk" of cash. Of course its risky to invest in one currency when your expenses are in another. That risk is by definition higher than investing in one currency and spending that currency as well -- the exchange rate risk goes to zero.

"Interestingly enough, the consumer price index (CPI) over this same period has only registered a 15% drop in the dollar's purchasing power."

From here on, the writer goes on the CPI conspiracy theory trail, alleging intentional underreporting of inflation. And his setting off point for this argument is the discrepancy between US Dollar inflation and US dollar depreciation compared to foreign currencies. The article should at least mention that these two numbers are not measuring the same thing. The US Dollar Index is not an inflation measure. Inflation is not even supposed to theoretically equal depreciation. It has more to do with speculation on future interest rates in different currencies, with other rates of return, with countries comparative GDP projections, etc.

"Any attentive consumer knows that cumulative price inflation since 2002 has been closer to 50% than 15%. This corresponds to the CPI being understated by about 5% a year. One study suggested that the CPI index has been understated by about 7% per year."

This is where the article gets laughable. "well EVERYBODY knows that blah blah blah" is never a good argument. The writer plucks a number out of thin air, and then plucks "one study" out of thin air. Link please? Who did the study? How do I as a reader know that this study wasn't just fabricated if there is no citation whatsoever? Plus it is borderline plagarism to use the conclusions of another's work without giving even the slightest credit to that person, not even to mention who the person is.

Marrotta should be embarassed at the poor quality of the logic and writing in this article. And FMF, you are surely less responsible for this than they are, but you should not allow misleading, unsupported, and possibly plagaristic arguments to stay up once you're made aware of them.

Attentive consumer knows that cumulative price inflation since 2002 has been closer to 50% than 15%

An accusation like this requires rigorous proof. I don't see it.

Now, I'm not a supporter of this political administration. Not by any stretch of the imagination. But if they had underestimated inflation by this much, surely we'd know. Academics and financial industries study this in detail. There'd be an uproar. It doesn't even pass the smell test, I haven't see 50% inflation here.

FMF is losing credibility by re-posting these Marrotta articles. It's like someone went freelance from the Heritage Foundation.

Looking ahead, I see a post on candidate's net worth, I'm sure there's a tie to personal finance there somewhere - I'm looking for it. I'd rather see fewer, better thought out posts.

[Harmony]

I am by no means a financial expert. The other responses have done a much better job of showing the holes in your logic better than I could.

I will comment on the "Any attentive consumer knows that cumulative price inflation since 2002 has been closer to 50% than 15%"

I consider myself a careful comsumer, I track my expenses on a monthly basis. The only expense I have that has increased 50% is the cost of health care, everthing else from housing to food is closer to 15% or less. The hamburger that was $1.00 in 2002 is now $1.05. Perhaps the point your trying to make is that the hamburger would now cost $1.50 in Europe. If so, I still wouldn't call cash a risky investment.

The only risk to a cash investment is decreased buying power due to inflation.

[Jake]

FMF, nothing to say here?? Quite unusual for you.

[FMF]

Jake --

What would you like me to say?

[Jake]

If you have nothing to say about the above, that speaks at least as loudly as any comment you could have chosen to make.

[FMF]

Jake --

I'm sorry, I missed the memo. Who again died and made you the sole authority on me, this blog, and personal finance?

I've written just under 5,000 posts on this blog and there are going to be some (a lot?) that people don't like. So be it. If everyne agreed with everything I posted, it would be a bit boring, wouldn't it?

As far as Marotta goes, I have this to say:

1. Their stuff is published in various publication (of which I'm probably the least), so it's not like they're a fly-by-night operation.

2. They have a financial planning business. And while that doesn't qualify them as "experts" (you know what I generally think of planners), they at least have knowledge behind what they write about.

3. If you're going to make accusations of plagarism on their part, I'd LOVE to see PROOF. Otherwise, you're guilty of the unsupported claims you accuse them of.

4. If you'd like to bash them, go ahead. Here are some ways you can do it:

A. Go to their site/contact them. Tell them what you think of their advice.

B. Rave about it on your blog. I'm sure your readers would love to hear about this.

5. If you'd like to bash them, here's a way you are not going to do it: by leaving your biased (and thus far unsupported) comments all over this blog. Feel free to comment and give your disagreement on the posts containing their stuff, but once you start going to other posts and leaving links to what you're saying, that's going too far. It junks up the blog for the sake of one person's agenda, and I'm not going to have it.

I've always enjoyed having you here as a commenter and I hope you continue. But if you insist on harping on a dead issue, I think it's probably better for you to move on. There's a lot more we can both do to be productive with our time. It's up to you.

There, was that enough of a comment for you?