I’m very pleased to introduce this guest post by Pete Comley, author of the hit free eBook, Monkey with a Pin. (Now also available as an iTunes podcast). Take it away Pete!

“Over periods of five years, the returns from shares have historically beaten cash around 80% of the time. Over 10 years, this rises to about 90%, and for 20-year periods, it’s 98%. With odds like that, investing [in shares] for the long term remains one of best ways of building your wealth.”

The above comment from The Motley Fool’s “10 Steps to Financial Freedom” has become the accepted orthodoxy by most investors.

What’s more, we are now living in a period of amazingly low interest rates. Base rates are at their lowest level for hundreds of years.

So what is the point of holding cash?

In this post, I will argue that the superiority of shares is not as great as the finance industry would have you believe. In addition, cash does have some key benefits like cheapness (no charges), simplicity, low risk, and optionality.

Cash is not without its own issues, and I’ll discuss how to mitigate these.

However, it is my view that neither cash nor equities are likely to beat inflation over the next five years. This article discusses how I’m going to play the ‘bad hand’ we all seem to have been dealt.

The effects of financial repression

Firstly, why am I so negative about the coming years?

It is not because of the Euro crisis per se or the stalling Chinese (and therefore world) economy. It is the debt mountain everywhere.

History suggests that there is only one easy solution for governments to this debt mountain, and that is something called financial repression.

The UK government has a track record of using this solution since Napoleonic times. It does two things:

• Firstly, it creates high inflation to erode the real value of its debt.

• Secondly, it suppresses interest rates to ensure it has to pay as little as possible to service its debts in the meantime.

The Bank of England appears to be enacting this time honoured strategy. Using QE to buy government debt not only ensures rates stay low (for the time being) but also that at some point soon all that money supply is going to fuel inflation. The blue touch paper has been lit and the fireworks display is just starting.

Historically – i.e. the last 50 years – interest rates averaged about 2% above inflation. But this is probably not going to happen over the next 5-10 years due to financial repression. Instead, even the best interest rates are going to be lucky to match it.

Equities trading sideways and consolidating

So given my views on cash, why am I writing a blog post arguing its benefits over equities?

Because equities are not going to do much better,  in my view – at least not for a few years. We seem to be stuck in a sideways consolidation secular bear market, and have been for 12 years. These typically run for 13-16 years or thereabouts.

Source: Barclays Equity Gilt Study 2011. UK equity index without dividends but adjusted for inflation.

Until we break out of this into the next secular bull market (which would see the FTSE 100 make new highs above 7000), the average equity holding is going nowhere. A report by Deutsche Bank published in late 2011 estimated that the average net return of the stock market over the next decade will be barely above inflation (+0.6% per annum).

When is cash not cash

But this isn’t my main issue with the finance industries’ claim that equities outperform cash. I think their argument has some serious flaws, as I outline in my book Monkey with a Pin.

To start with, all the key comparative historical studies like the Barclays Equity Gilt Study and the Dimson, Marsh & Staunton data don’t use a measure of ‘cash’ that you and I think of as cash. They normally use something called a ’91-day treasury bill’. It is a wholesale instrument that’s unavailable to the average saver (unless you have a spare £1/2 million or so).

When they do attempt to compare with building society rates, they use accounts that no one else is using and are not representative of the market.

Since 1998, Barclays has been indexing against the postal Nationwide InvestDirect account. It pays just 0.2% (i.e. 3% below many instant access accounts). If you adjust for this alone, the gap between cash and equities narrows.

The missing 6%

As if this treatment of cash was not bad enough, in my book I also show that the average investor is losing 6% a year from their theoretical equity return.

The main reason they never achieve the projected returns that the industry promotes is charges – be they fund TERs, hidden charges, or just share trading commissions, stamp duty, and bid offer spreads.

You also have to factor in that on average, most private investors have a negative alpha (skill level), especially when new to investing.

Lastly, the theoretical return is usually based on measures that exclude survivorship bias, so that also drags down the actual return versus expectations.

When you add in this further negative 6% drag on equity investing and compare it with the real return on cash over the last ten or even 20 years, the comparison actually favours cash.

Cash vs equities scenarios

There are ways to mitigate this average 6% loss in equity investing, as I describe in my book. The key one is to buy and hold a very low cost passive index tracker, which gets your loss down to about 1% per anum.

However even after doing so, the actual equity return over the next five years is probably going to be less than inflation, if Deutsche Bank is right:

This means that the best-case scenario for both high interest rate cash ISAs and low cost tracker equity investments will not match inflation.

How to get the most from cash

Having debunked the industry brainwashing that holding cash is a completely stupid idea, let’s look at it in more detail and examine how you might best do so.

First, a big caveat: Many people will not do that well out cash.

In my scenarios above, many people will be lucky to get back any more than they put in, in real terms, if they pick the wrong ISA account (the fourth bar in the graph). But remember that I think the same will happen to the average share investor, too, by the time you factor in their missing 6% a year (far right bar above).

Indeed, the biggest issue with cash is that most people put up with receiving a much lower rate of interest than they could theoretically get.

It may hardly seem worth bothering to switch accounts for 1% or so more on the interest rate. However what most savers fail to realise is that due to compound interest, the impact is quite big, as the following chart illustrates:

We all live busy complicated lives. Although we seem happy to spend a lot of time researching exciting share opportunities, we are reluctant to spend a fraction of that effort on ensuring we get a good interest rate on our cash. Even if we start with good intentions, we often find a few years down the line that our introductory bonus rate has long expired without us doing anything about it.

Savings tip: Want to audit your interest rates? This handy tool from Which? enables you to easily check the rates on your old accounts.

How to be a rate tart

I’ll admit it, I’m a bit of tart. So what are the options I’m using (or have considered using) to ensure I maintain good rates on my cash?

1. For money I’m prepared to put away, I use fixed rate schemes for a year. They automatically write to me near the end and tell me it is expiring. That forces me to go online and compare the rate and if necessary switch provider.

2. I try and time my accounts so all the bonuses and fixed rate schemes expire at a couple of points in the year (so I don’t keep having to think about it). The March ISA season is a good expiry point to renew at good rates.

3. I am looking at using the free MoneySavingExpert Tart Alert tool. By registering the expiry date with it when you set up the account, it will text or email you six weeks before the end to remind you to switch.

4. I have looked at the Governor account. It is an intermediary website, which sends you alerts when your accounts interest rates decline and makes it easy for you to switch. Why have I not used it? A few reasons: It won’t take transfers in, it only takes fixed term deposits, it has a very limited choice of accounts (just five small building societies currently show offers), and the rates are below the best elsewhere (as Governor takes its cut).

5. I’m thinking about opening an Investec High 5 or High 10 account. These offer a rate that is equivalent to the average of the top 5/10 saving accounts, respectively. The main snags are you need a minimum of £25,000 to tuck away, and you also have to give 6/3 months notice, with no early withdrawals permitted. You can’t use it for ISA funds, either.

All in all, I am still likely to be using a manual process for accounts in the future, despite the potential financial innovations out there.

Tax doesn’t have to be taxing

Another issue with cash often overlooked in the comparison with equity investing is that of tax.

Few people pay much tax on their dividends or gains from shares because they are within their tax allowances, they are basic rate taxpayers, or else the shares are sheltered in tax-free wrappers like ISAs and pensions.

Compare this to cash savings, where many pay the 20% basic rate, if not higher rates of 40% to 50%.

The annual cash ISA allowance is (for some reason) just half the potential stocks and shares ISA allowance, amounting to £5,640. This – together with the fact that you can’t get the money out of an ISA and then put it back in – means that many of us have savings accounts where we’re paying tax.

Tax can massively reduce your returns, as the following graphic illustrates:

Sipping your glass empty

If this were not bad enough, those trying to hold cash within SIPP pension schemes typically receive near-zero returns on it.

There is a solution to this, however, which I use myself. That is to have a SIPP set up with a provider that allows you to put your cash in building society and bank accounts of your choosing. Admittedly they have to be postal-administered trustee accounts, which restricts your choice severely, but if you look at Investment Sense’s listings, you’ll see the rates similar to the usual best buy tables – indeed the current five-year fixed rates are higher than the comparative ISA ones.

A word of warning: Suitable SIPP accounts don’t come cheap in their running costs, nor in the set up charges for each building society account. You are probably going to need a pension pot in excess of £100,000 to make them truly worthwhile.

Spreading your risk

Any discussion of cash savings can’t pass without a reminder about the Financial Services Compensation Scheme. In the event of another banking crisis that threatens your cash savings, the FSA will cover you for up to £85,000 deposited with each banking group in the scheme.

To ensure you’re protected, you must understand which banks are part of which groups – see the FSA for full details. You must also check before you set up an account to make sure it’s covered at all – this is particularly important for international banks.

If you have more than £85,000 to invest, then you are going to have to open and administer two or more different bank accounts (which can significantly add to your hassle/costs in a SIPP, for example).

Optionality

Having looked at all these negatives, I’m sure many of you still think I’m mad bothering with cash. But the main reason I do so currently is optionality.

At some point in the next few years, I think there is a good chance that asset prices will mark a significant low point. If you go back to FTSE chart I showed earlier, there has to be chance that we’ll see another stock market low before we finish this secular bear market.

At that point, I want to have as much cash to invest as I can muster. I don’t want to be thinking that my portfolio has just declined 50% and the end of the world is coming. I want to be thinking positively like Buffet does in such situations. I want to be shopping in the biggest sale we’ll potentially see for another 20 years afterwards.

If I’m wrong and the FTSE does not put in a new significant low, I plan to invest when we break out of this sideways trading into the next secular bull market. At that point, the wall of cash out there is also going to pile in and drive stocks to new highs.

FTSE 20,000, anyone?

Concluding the case for cash

Holding cash at the moment is not a good idea, but in my view holding equities is potentially even worse.

I view cash as a short-term strategy to preserve my wealth in some form for the great potential opportunities to come.

So has Pete persuaded you to shake that equity monkey off your back? Or do you believe like me that now is already a good time to buy shares? Let us know below. (Note: I fully agree that cash is under-rated for private investors.)

Finally, my thanks to Pete for this very comprehensive article. Don’t forget to download his free eBook!

Important: What follows is not a recommendation to buy or sell shares in any companies or trusts. I am just a private investor, storing and sharing my notes. Read my disclaimer.

I have the impression the stock market has currently taken a dislike to private equity and unlisted holdings, as well as any ambiguity or a lack of transparency (although the latter is usually partly in the eye of the beholder).

It won’t be like this forever. A few years ago, the big growth and income investment trusts were trading at a sizeable discount, whereas now they’re all on a premium. Investors today want income. Fashions change.

I suspect that someday, all other things being equal, the following companies will be more favoured and the discounts will be smaller – hopefully because the Net Asset Value (NAV) at least held up, and the share price rose.

But nobody can be sure – the discount could narrow instead because the NAV falls – and I certainly have no timetable in mind in most cases. As ever do your own research and make your own mind up if you’re interested in pursuing these discount to asset plays.

Daejan

Ticker: DJAN

Many commercial property companies are now trading close to NAV again, but not Daejan. It’s a property company run and partly owned by the founding Freshwater family. It owns commercial and residential property in the UK and the US, and it tends to issue very scanty releases. I get the impression most of its portfolio is not prime, though I think it has some prime assets, including in London. A good run had taken the share price to well over £32 by the start of April, but it’s now back at £27. At the interim stage last September the company said it had assets of £51.53 per share. Assuming no change since then, that’s a 47.6% discount to book. The shares tend to trade at a big discount, mind, but they did climb to a premium in the last property boom.

Electra Private Equity

Ticker: ELTA

Private equity trusts were hit hard in the downturn, as some private equity companies collapsed or were heavily diluted by the sheer weight of their debt. Electra Private Equity has come through fairly well, and recovered from a sell-off that took its discount to NAV to over 60% in 2009. As I write the discount is estimated at 31%, according to Trustnet, and it was recently even bigger1. Private equity should trade at a discount due to the uncertainty about valuations, but a smaller discount of 15% to 20% is feasible in better times. Electra says it’s cautiously picking up good deals, including the assets of deleveraging banks. You’ll definitely want to dig into its reports; the very recent presentation to analysts [PDF] is a good start. Note that while Electra itself doesn’t have much debt, most of its portfolio companies do.

Caledonia Investments

Ticker: CLDN

I have written about Caledonia before. Ten months on, the discount has widened from 20% to over 30% according to Trustnet. If the share price was to rise to the current NAV, an investor would see a nearly-45% gain. If it rose because the NAV was rising too, the gain would be even greater. Unfortunately, according to its latest annual results Caledonia’s NAV declined 7% in the past financial year on a total return basis, compared to a 1.4% rise in its benchmark. I still have money in Caledonia, but so far the market has been right. With even blue blood RIT Capital Partners recently flirting with a discount again, less illustrious Caledonia is probably one to tuck away and forget about for five years.

Gresham House Investment Trust

Ticker: GHE

I said above that there’s not usually a timetable with an asset play, but that’s not quite the case with Gresham House. Its managers have decided they can’t make its brand of property investing work in shareholders’ favour in the current climate, so rather refreshingly they’ve decided to liquidate the portfolio and return all cash to shareholders. Recent full-year results put basic net assets at 427p per share, compared to a mid-price of £2.82 as I write. There’s a horribly wide spread, which could see you pay £2.95. On that basis there’s a 30% discount to NAV, or a gain of 44.5% in maybe one to three years. Management will still be drawing expenses, however, which could reduce the NAV; set against that a recent disposal went above book value.

Hansa Trust

Ticker: HAN / HANA

This is a similar deal to Caledonia – a big and old family-founded investment trust that is trading on a steep discount despite a very good long term record. Hansa was at least beating its benchmark over the latest six month period it officially reported to investors, though admittedly that takes us all the way back to September 2011. Its portfolio is more straightforward than Caledonia’s, except that roughly 40% is in one listed company, Ocean Wilsons (Ticker: OCN), a Brazilian tug operator that has its own emerging market portfolio. According to Trustnet, Hansa’s non-voting shares are on a 25% discount.

Jellybook

Ticker: JELY

Jellybook Limited is a cash shell that raised money last year to buy into a social network company. It has yet to make its investment, and as of 31 December 2011 it was sitting on £10.5 million in cash, against a market cap of £7.45 million as I write. That means there’s a near-30% discount on cash here – and cash is cash. Of course the manager plans to pump the money into a currently unknown company that I think is unlikely to be bought cheap, though with Facebook shares declining perhaps the shine has come off the sector. In any event, in the dotcom days (when the manager was also active) a shell like this might have traded at a premium. Despite the discount on cash it’s probably the highest risk of all these shares, as we have no idea where the money will go.

Ventus 2

Ticker: Ven2

Another very high risk share, this backer of wind turbine projects is suffering from multiple simultaneous reasons for its discount: It’s a little understood VCT, it’s horribly illiquid, a couple of its investments have been written down to near-zero, management has changed – oh, and the wind didn’t blow so much in the UK in the past couple of years, making potential investors lairy of the historical data. Other less cultured blogs would use a colourful term for multiple adults enjoying sexual relations at once to describe this confluence of negative influences, but I’ll just call it the group hug from hell. The bottom line is that the shares are trading at a 37% discount to a marked-down NAV. The potential catalyst for change is that new management says it’s cleaned the stables, and now hopes to deliver a dividend of 3.5p a year for the next three years, rising to 4p to 6p within five years. A disastrous foray into non-wind energy means its original investors will probably never see the 6p to 8p annual payout first targeted, and the high TER means there’s little chance of NAV growth, but a nimble nibble might secure a long-term tax-free income of around 10%. Ventus 1 shares once traded (ludicrously) at a premium to NAV, but I’d personally only invest from here in the hope of perpetual junk bond-like income.

Note: As I write I own shares in Caledonia Investments and Ventus 2, and may or may not buy or sell shares in all these companies. I take no responsibility for any decisions you make as a result of this post – read my disclaimer and do your own research. Remember most people will do better investing passively.

1. Note that Trustnet uses an estimated NAV figure. For greater confidence when buying into a discounted trust, you need to wait until the company issues an up-to-date NAV, and then time your purchase accordingly. [↩]

Good reads from around the Web.

The advanced cloud-based super-server infrastructure that powers Monevator (i.e. two tin cans with a bit of string tied between) almost melted down this week, thanks to the follow-up from iii’s surprise fee hike.

Last week we were bombarded with readers alerting us via email to the cost-grenade lobbed into the midst of their best-laid plans.

They were angry and confused, but this week they fought back, swapping strategies in the comment sections of our first and second posts about the iii whammy.

If you’re one of the thousands of subscribers who now reads Monevator through your email in-box, you may not know that many of our posts get dozens of comments. Those two posts about iii now have nearly 100 between them.

What’s great about the comments on this website, so far at least, is that they are overwhelmingly constructive and polite, whether it’s feedback on our articles or readers helping each other out.

Having seen discussion forums ruined by abusive posters and the comment sections of online newspapers turn into a cesspit of bigotry and abuse, I show zero hesitation in deleting rude and willfully misleading or antagonistic comments. But so far I haven’t had to delete more than a couple a month.

In fact, the iii incident has made me wonder again about whether to introduce a discussion forum on Monevator.

One reason not to do so is there’s plenty of places where money-minded folk can swap tips across the Internet.

Another forum would hardly fill a void – it’d be more like elbowing your way to the bar!

The other reason is I’m pretty sure it’d be a time sink. A financial website forum isn’t like a discussion board for cat lovers. The potential for dangerous misinformation is vast, making timely moderation vital.

On the other hand, I imagine a simple board split across three or four sub-sections – Passive, Active, Financial Freedom Strategies, and Money Making Tips, or similar – could grow into something quite nice.

What do you guys think?

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