Is cash king once again?

See the bigger picture with your investment strategy

By Samuel Rossouw

2/9/2023

I’m frequently reminded of the good old days when the Springboks ran the ball, fuel prices were low, and you could earn decent interest on your money market investments.

Given the current higher interest rates and recent stock market fluctuations, it might seem reasonable to consider locking your money into a five-year fixed deposit at this moment. However, unless you know exactly what state the world will be in after a decade, there are essential factors to consider.

In February 2000, the South African Reserve Bank implemented an inflation target range of 3% to 6% to maintain economic and financial stability. This policy led to a much closer link between interest rates and inflation. Consequently, interest rates began a significant decline, making the prospect of ever seeing interest rates around 15% again highly improbable.

It’s well-known that stocks outperform money market investments over the medium and long term. Historical data consistently demonstrates that cash is clearly NOT king across nearly all measurement periods. Interestingly, there is almost no discernible connection between interest rate cycles and equity investments. Please refer to the accompanying graph.
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Imagine if you had decided to invest your money at a rate that was 2 percentage points below the prime lending rate during the peak of the interest rate cycle in September 2002. In such a scenario, your returns would have notably fallen behind those achieved by investing in the local equity market during that same period (15% per year compared to 28.19% per year).

If, on March 18, 2016 (at the peak of interest rates), you had allocated your money to different asset classes, an investment in local stocks would have generated a return of 7.96% per year versus an 8.50% per year return on a fixed deposit (2 percentage points below the prime rate).

You can deduce that you might either win or lose by committing your money for five years. However, what happens after those five years, when you must reconsider your investment strategy?

In the earlier example, the prime lending rate stood at 13.50% on September 13, 2007, which was 3.50 percentage points lower than five years prior. Based on past experiences, an investor might have preferred allocating their money to a stock-like investment (which had performed better over the preceding five years). However, the stock market only grew by 7.64% per annum over the subsequent five years (from September 13, 2007, to September 13, 2012), and a fixed deposit (prime lending rate minus 2 percentage points) would have fared better again.
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Please refer to the graph below for potential outcomes for the investor.
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A similar scenario would have unfolded in 2016. If an investor had secured a rate of 8.50% on March 18, 2016, they would have outperformed the 7.96% per annum return on the stock market over the following five years. However, if they had reviewed their strategy in 2021, they would have had to decide whether to secure a rate of 5%. Between March 18, 2021, and August 15, 2023, however, the JSE grew by 14.44% per annum.

Here are some key points to consider:

  • Interest rate cycles also bring a degree of volatility. Altering your strategy every five years to predict interest rates and stock market movements is a risky strategy, as it may cause you to entirely miss out on bull runs in stock markets.
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    A balanced portfolio aims to eliminate the guesswork of choosing asset classes and consists of a combination of stocks and cash.
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  • During market declines, cash can be utilised within the fund to purchase stocks at a discount.
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  • In rising stock markets, profits can be realised and parked in cash.
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  • In periods of high-interest rates, exposure to cash can be increased, and the opposite approach can be taken in a low-interest rate environment.
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The impact of taxation on money market instruments and fixed deposits is often underestimated. Besides the fact that interest income is fully taxable, it also raises the average tax rate on your remaining investment portfolio or salary.

In a unit trust fund, the interest component is taxable, but the capital gains component (taxed at a considerably lower rate) applies only when you sell 100% of the fund.

In the previously mentioned example, if the investor had allocated 100% of their funds to a fixed deposit on September 13, 2002, their after-tax return after ten years would have been 8.61% per year (13.25% before taxes), while an investment in stocks (if fully liquidated) would have generated a 15.37% per year return after taxes (17.92% before taxes).

Therefore, the impact of taxes has significantly widened the return gap (favouring stocks over cash) by nearly 123%! (Assuming a 35% marginal tax rate and a 3% dividend rate.)

There is no one-size-fits-all strategy, but it is worthwhile to understand why a particular strategy is being pursued with your money.

Samuel Rossouw is a certified financial planner and director of Woodland Wealth. Contact him at info@woodlandwealth.co.za.

Although all possible care has been taken in the preparation of this document, the factual correctness of the information contained herein cannot be guaranteed. This document does not constitute advice and anyone who intends to take any financial action based on this document is strongly advised to first consult with his/her personal financial advisor. Woodland Wealth is an authorised financial service provider with FSP no. 5966.

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