The realities of investing – Part 2

In our second note on the realities of investing we turn our attention to cash. Cash feels safe. It’s familiar, stable, and seemingly risk-free. But over the long term, relying solely on cash can be one of the riskiest strategies for investors. True safety comes not from avoiding risk, but from balancing cash with growth assets that protect your lifestyle against inflation and falling income.

When interest rates fall, cash income can collapse

When interest rates are high, cash can be very appealing. But interest rates move in cycles, and they can change quickly. We’ve just seen this happen. The official cash rate (OCR) has fallen from 5.5% in August 2024 to 2.5% today. Term deposit rates have also fallen given the close relationship between the two.

A saver rolling over deposits is now earning nearly 35% less than a year ago. For someone reliant on their savings, that’s the difference between budgeting for $60,000 of annual income and suddenly only receiving $39,000. And with further cuts expected, income could fall further from here.

The speed of change in interest rates can also be brutal. In 2008, the Reserve Bank of New Zealand (RBNZ) cut the OCR from 8.25% to 2.50% in just 10 months. For a saver with $1 million in deposits, annual income collapsed from over $80,000 to just $25,000. That’s like going from planning for a holiday to suddenly worrying about if you have enough income to cover your everyday bills.

This is why it’s important for savers to understand that while cash offers stability, its income potential is highly sensitive to changes in interest rates. Income rises when the RBNZ is hiking rates, but it shrinks just as fast when they cut. So, while the amount you have saved may not change, movements in interest rates can have a significant impact on your income.

Inflation: the silent destroyer of long-term wealth

Even when rates are stable, inflation steadily eats away at your savings. Over the past decade, inflation averaged 2.9% per year, reducing the purchasing power of $1 million to around $750,000 in today’s money. Stretch that out over both your accumulation and retirement period, and the impact is devastating. This is why it is essential for long-term investors to ensure the after-tax return achieved exceeds inflation.

Own shares for inflation protection and income growth

Shares, unlike cash, can provide protection against inflation because companies are able to raise prices and grow their earnings. This makes shares one of the most effective ways to protect the real value of your money.

To illustrate this point, I have compared the difference between investing $1.0 million in a 10-stock New Zealand equity portfolio in 2015 versus 6-month term deposits. In 2015, the gross income from investing in either of these options was similar. The 10-stock portfolio would have provided around $41,989 of income (a yield of 4.2%), while 6-month term deposits would have generated $39,607 (a yield of 4.0%).

Fast forward to today, and the cash investor’s annual income is up modestly from $39,607 to $44,300, while the share investor’s income has grown by more than 150% from $41,989 to $107,751. The difference between the total gross income collected over this period from the two different investments is equally stark – $373,000 from investment in term deposits versus over $880,000 from the 10-stock portfolio of equities.

Over this time, the equity portfolio has also grown to more than three times its original value (from $1.0 million to $3.4 million), while cash has stayed flat. Even through shocks like COVID-19, dividends held up far better than term deposit income, which fell to just $8,233 (a return of just 0.82% on your capital).

This illustrates an important point; while dividends are not immune to disruption, they are ultimately tied to the growth in company profits over time. This provides investors with the potential for rising income and capital growth, two things cash can never provide. For someone relying on their savings for income, that’s life-changing. It’s the difference between just scraping by and having the flexibility to maintain – or even improve – your lifestyle in retirement.

Cash still has a role – but only in the right amount

Despite its risks, cash still plays an important role – a buffer for emergencies or short-term needs is essential. But holding too much can be costly. The key is balance: enough cash for today, and growth assets for tomorrow. Cash may feel safe because the balance doesn’t change – but real safety comes from protecting your future spending power.

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