Are bank deposits risk-free in the long term?

[Andrew365]

I have moved these posts from this thread :

Business sold, €4m to invest?

Age: 41 Spouse’s/Partner's age: 43 Annual gross income from employment or profession: 225,000 (+ 50% guaranteed yearly bonus for next 3 years) Annual gross income of spouse: 65,000 Monthly take-home pay: €13,000 combined (excluding bonuses). Mortgage payments of €2,065/month lions share of...

askaboutmoney.com

... the OP has achieved wealth, he has more money than his lifestyle needs and has no appetite to massively change. There is zero need to take on the risk of the stock market. Yes, it may rise 20% generating an additional 1million but to what ends?

My advice is to invest in your pension, buy whatever state investments are available and put the rest in the bank, give some to charity and congratulate yourself for a job well done.

 

[Brendan Burgess]

There is zero need to take on the risk of the stock market.

buy whatever state investments are available and put the rest in the bank,

Hi Andrew

That is the whole point.

A diversified portfolio of equities is less risky in the long-term than a state investment or a bank deposit.

As most people do, you are confusing volatility with risk.

Sure, his €4m could halve over the next 12 months. But a bank deposit could be wiped out entirely. The Irish state finances are in a terrible position and default, while unlikely, is certainly a possibility.

And even if the banks and the state remain solvent over the next 40 years, inflation could wipe out his investment.

I will add that to the list of mistakes to avoid. Put your money on deposit.

Brendan

 

[Andrew365]

Brendan, I have to disagree with you, inherently from market economics, a portfolio of Equities will be riskier than not investing in the market, hence why there is a risk premium for trading equities. In your point you are confusing default risk with the risk of an asset. Cash is less risky than equities as a fact. To compare apples for apples you would need to consider the probability of default of a bank vs the companies that you have invested in. A diversified equity portfolio is inherently going to have a larger Loss Given default given some sectors inherently have higher probability of defaults than Financial institutions. Banks in Ireland are in fairly good capital standing as of now, regulation over the last 10 years has ensured that.

Lastly an individual with over 4m in wealth has access to financial products that the average person does not, there are products that can be purchased (CDS single name / Index) to protect against the default of the Government of Ireland or said Financial Institution. A well diversified equity portfolio has no protection against default risk.

 

[Brendan Burgess]

Cash is less risky than equities as a fact. To compare apples for apples you would need to consider the probability of default of a bank vs the companies that you have invested in. A diversified equity portfolio is inherently going to have a larger Loss Given default given some sectors inherently have higher probability of defaults than Financial institutions. Banks in Ireland are in fairly good capital standing as of now, regulation over the last 10 years has ensured that.

Hi Andrew

There have been many examples of wealthy people invested in cash being wiped out. German inflation is probably the most dramatic.

Irish inflation has also dramatically reduced the wealth of cash investors.

If the OP buys a portfolio of equities, it's very likely that some of them will fall to zero. But the maximum loss on any investment will be 100%, the maximum gain on the others is unlimited and should compensate for that.

The Irish economy is in a very difficult position , and all the more so, because people don't recognise it. Irish banks could all topple down together. Probably not this year or next year, but over the longer term which is his investment horizon.

You would probably be correct if you were comparing a deposit in AIB with a €4m investment in one individual share. But a diversified portfolio of equities is less risky than bank deposits.

Brendan

 

[Gordon Gekko]

I would agree that cash is more risky than equities for a 40 year old.

Volatility is not risk; it’s just things going up and down.

Inflation is an actual risk.

 

[Andrew365]

Hi Andrew

There have been many examples of wealthy people invested in cash being wiped out. German inflation is probably the most dramatic.

Irish inflation has also dramatically reduced the wealth of cash investors.

If the OP buys a portfolio of equities, it's very likely that some of them will fall to zero. But the maximum loss on any investment will be 100%, the maximum gain on the others is unlimited and should compensate for that.

The Irish economy is in a very difficult position , and all the more so, because people don't recognise it. Irish banks could all topple down together. Probably not this year or next year, but over the longer term which is his investment horizon.

You would probably be correct if you were comparing a deposit in AIB with a €4m investment in one individual share. But a diversified portfolio of equities is less risky than bank deposits.

Brendan

Cash is still less risky and that is a fact. There are not many examples of individual cases your example is a macro one.

Why are the Irish banks going to topple? What insight do you have the support that statement?

 

[Brendan Burgess]

Cash is still less risky and that is a fact.

No. It is your opinion. Cash is less volatile - that is a fact. Over the long term, in my opinion, a diversified portfolio of shares is less risky than cash.

I am not saying that the Irish banks are going to topple. But it is a risk especially when looking at a 40 year horizon. And no investor should ignore that risk or assume that it is zero.

Brendan

 

[Gordon Gekko]

Cash is still less risky and that is a fact. There are not many examples of individual cases your example is a macro one.

Why are the Irish banks going to topple? What insight do you have the support that statement?

Over a multi-decade time-horizon, I would argue that cash is far riskier than a diversified share portfolio. The former is almost guaranteed to lose purchasing power over time. The latter should do pretty well.

And, to echo Brendan’s point, it is generally accepted that depositors would be “bailed in” if the banks hit the rocks again.

 

[Andrew365]

I am sorry but in my opinion you are both wrong. What you are pointing out is that over a longer time equities will return more than cash, per the poing "cash will lose purchasing power". I agree with this sentiment, however that is different from the risk of the asset. Cash is inherently less risky than stocks, or else all deposits would be held in Equity rather than cash.

Regarding the comment on the banks facing potential issue is just your speculation. However, every company has a probability of default, an Irish bank is riskier than a large UK bank such as Barclays but is less riskier than Greek or Italian Banks.

What is the argument to support cash being riskier other than currently putting it on deposit is not going to beat inflation? What can actually happen to the cash or happened to it say in 2008 during the financial crisis?

 

[RedOnion]

What is the argument to support cash being riskier other than currently putting it on deposit is not going to beat inflation?

But inflation IS the risk over a 30 to 40 year horizon. If not every 30 year old in the country would be advised to put their pension in cash. Why would it be different here?
The credit risk can be diversified away with cash, but the inflation risk can't.

 

[Andrew365]

But inflation IS the risk over a 30 to 40 year horizon. If not every 30 year old in the country would be advised to put their pension in cash. Why would it be different here?
The credit risk can be diversified away with cash, but the inflation risk can't.

Inflation risk is an external factor to the cash asset. If I put $100 on deposit at 1% (risk free rate) for 5 years, after 5 years providing the institution has not defaulted I will have $101. However, I can be certain that I will have $101 at the end of 5 years and that satisfies my risk appetite. In summary I have exposure to 3 risks, inflation, bank defaults, currency devaluation, and the bank is willing to pay me a risk premium of 1% to take these risks or in market theory this is called the 'risk-free rate'. The risk free rate can be described as the difference between yield on a US Treasury and Inflation and for simplicity is 1% in this example.

If I put $100 into a broad based equity index tracker for 5 years, it may go up or it may go down, assuming the market moves 10% over the 5 years, I could end up with either $110 or $90. In this case the risk premium is 9% (10% - risk free rate). This reflects that in order to generate a larger return I need to take more risk and therefore I expect a greater return (risk premium).

Now we live in a world with 0 or negative interest rates which is why risk free assests sometimes are generating a negative yield which makes the above slightly more nuanced because you have to come to terms that the purchasing power could be less.

Even if inflation is the risk, it is very very very remote that it could match the potential volatility of the stock market. If it did then putting money on deposit would demand the same return as investing in the stock market. If inflation jumped to 10%, you would need the stock market to outperform that as inflation is also embedded into your stock market investment.

The points made do not prove that Equity is less risky than cash because the risks inherent to cash are still present in Equity investments, hence why there is a larger risk premium.

I hope this is clear but happy to clarify further.

 

[Brendan Burgess]

If I put $100 into a broad based equity index tracker for 5 years,

Even if inflation is the risk, it is very very very remote that it could match the potential volatility of the stock market.

Hi Andrew

You are making the common mistake of confusing risk and volatility.

None of us would disagree that over the next 5 years, equities are more "risky" than cash. It is quite possible that stocks will be lower than they are today. It's unlikely that inflation or a bank default will wipe out today's deposit.

But over the longer term, volatility of the stock market does not matter but the risks of inflation and bank default increase.

You are quite entitled to your opinion that the stock market is riskier in the long term than cash and I am entitled to disagree with you. But you are not entitled to say that cash is risk-free.

Brendan

 

[RedOnion]

If I put $100 on deposit at 1% (risk free rate) for 5 years, after 5 years providing the institution has not defaulted I will have $101.

I'd hope you'd have $105?...

I hope this is clear but happy to clarify further.

You have suggested earlier that the best place for a 41 year old to put the money that they will use to fund the rest of the life (let's say up to 50 years) is in cash. So let's forget about 5 year horizons, and your risk appetite. Where should the OP put their money for their time horizon?

For the record, I've funds that I've invested for a 5 year horizon which I've put into state savings. I want certainty on that money in that timeframe, so that's where it is.
I've also invested for my children's future which won't be needed for 12+ years. That's predominantly in equities.
And my pension (I'm in late 30's) is 100% invested in equities.

 

[Andrew365]

Hi Andrew

You are making the common mistake of confusing risk and volatility.

None of us would disagree that over the next 5 years, equities are more "risky" than cash. It is quite possible that stocks will be lower than they are today. It's unlikely that inflation or a bank default will wipe out today's deposit.

But over the longer term, volatility of the stock market does not matter but the risks of inflation and bank default increase.

You are quite entitled to your opinion that the stock market is riskier in the long term than cash and I am entitled to disagree with you. But you are not entitled to say that cash is risk-free.

Brendan

I have not made the mistake of confusing risk and volatility? Please explain.

I do not disagree that with an increase in time default increases but are you saying that over time banks have larger chance of default than corporates?

I did not make the statement cash is risk-free, I described the concept of risk free rate which is the basic foundation concept of portfolio theory.

It is just very surprising that I am having to try and rationalize investing in cash as less risky that Equities.

 

[Andrew365]

I'd hope you'd have $105?...


You have suggested earlier that the best place for a 41 year old to put the money that they will use to fund the rest of the life (let's say up to 50 years) is in cash. So let's forget about 5 year horizons, and your risk appetite. Where should the OP put their money for their time horizon?

For the record, I've funds that I've invested for a 5 year horizon which I've put into state savings. I want certainty on that money in that timeframe, so that's where it is.
I've also invested for my children's future which won't be needed for 12+ years. That's predominantly in equities.
And my pension (I'm in late 30's) is 100% invested in equities.

For simplicity it was 1% over the 5 years not p.a., if it was annual it would actually be $105.10.

You have just proved the point, you have a different risk appetite for different situations and investment horizons. You are invested in 100% equities for your age because you are trying to maximized returns and the time horiozon allows you to do so and can negate some of the stock market cycles. The OP has already achieved wealth, he does not need to chase it. So why take the risk that when he does need the money it is during a downturn?

If you are in your late 30's for a significant part of your investment history you have only seen the stock market go up.

 

[RedOnion]

If you are in your late 30's for a significant part of your investment history you have only seen the stock market go up.

I probably understand the risks of stock market, and particularly stock picking, better than most. I personally lost quarter of a million during the crash (all equities).

So if you're going to be condescending you can pick somebody else.

 

[Andrew365]

I probably understand the risks of stock market, and particularly stock picking, better than most. I personally lost quarter of a million during the crash (all equities).

So if you're going to be condescending you can pick somebody else.

Based on the comments thus far people would put that down to volatility and if you held the portfolio for the long term it would eventually return. It is not that black and white or else you would maybe be saying you lose 250k but it has since been recouped by holding the portfolio for a further 12 years?

My advice for the OP remains as stated, given the current economic climate investing his 4m in the stock market carries too much risk.

The comment was not intended to be condescending, since 2009 the market has gone in one direction.

An additional thought, if the advice continues to be invest a substantial amount into the market I advice the OP to purchase downside protection via options. Do not enter the market exposed to only one direction.

 

[RedOnion]

It is not that black and white

It's very black and white in my case.
I lost the money. I think I know better what happened to my money than you do?
I never said I had a properly diversified portfolio.

 

[Brendan Burgess]

I see now where you are coming from.

You believe that you can time the market and that it is overvalued? Therefore he should be in cash until the market is fair value again?

I don't have your ability to time the market. If I did know that the market was going to fall, then I would advise as you have.

However, I don't think it's possible to time the market.

Or do you accept that you can't time the market, but it's just that after such a long period, the risk is higher?

Brendan

 

[Andrew365]

I see now where you are coming from.

You believe that you can time the market and that it is overvalued? Therefore he should be in cash until the market is fair value again?

I don't have your ability to time the market. If I did know that the market was going to fall, then I would advise as you have.

However, I don't think it's possible to time the market.

Or do you accept that you can't time the market, but it's just that after such a long period, the risk is higher?

Brendan

Where did I say that?

Based on your comments you are mixing and matching different topics to support your point but to a person with a detailed understanding of risk management it is clear there are gaps in your logic. From what I can see you think Irish Banks defaulting are more likely over the long term versus any Corporate in a well diversified Equity Portfolio. Therefore holding cash in a bank is riskier than putting it in the stock market.

So for my understanding you believe that if I have $100 to invest for 20 years, with the goal of having $100 (plus nominal bank interest) in 20 years time (zero risk appetite), the less risky option is to invest Equities rather than hold it as cash?