The Hidden Risks of Cash

Cash has long been considered a safe haven in the world of finance, with its stability and liquidity making it a preferred choice for those seeking security. But while cash may seem low risk, it is far from risk-free. Beneath its perceived safety lie several threats that can erode its value and undermine its reliability. From inflation to counterparty risks and physical vulnerabilities, let us explore why cash is not as foolproof as it appears.

Inflation

One of the most significant risks of holding cash is its vulnerability to inflation. Inflation refers to the gradual increase in the price of goods and services over time. While inflation is often viewed as a normal economic occurrence, its impact on cash can be severe.When inflation rises, the purchasing power of cash diminishes. This means that the same amount of money buys fewer goods and services as time passes. For example, if inflation averages 3% per year, R100 today will only have the purchasing power of about R74 in 10 years. Even in periods of low inflation, the compounding effect over several decades can significantly erode the real value of your savings. Holding cash, therefore, exposes you to the risk of losing value in a way that is not immediately visible but deeply impactful over time.

Counterparty Risk

Many people believe that keeping cash in the bank eliminates risk. While banks are generally considered safe, they come with their own set of vulnerabilities, primarily in the form of counterparty risk. Counterparty risk refers to the possibility that the institution holding your cash may fail to fulfil its obligations.Banks operate by taking deposits and lending them out, which means your cash is not physically sitting in a vault but is instead part of the bank’s broader financial operations. In extreme cases, such as financial crises, banks can experience liquidity issues or even insolvency.

Physical Cash

Holding physical cash might seem like a way to avoid the risks associated with banks, but it introduces its own dangers. Cash kept at home or in a safe is exposed to theft, loss, and physical damage. A break-in, fire, or even simple misplacement can result in a total loss of your money. Unlike digital or bank-held funds, physical cash has no recovery mechanism—once it’s gone, it’s gone.Additionally, large amounts of cash can be cumbersome to manage and may raise suspicion or regulatory concerns if used in transactions, leading to potential complications.

The Illusion of “Low Risk”

The concept of cash as “low risk” stems from its stability in nominal terms. Unlike stocks or bonds, cash does not fluctuate in value from day to day, which provides a sense of security. However, this stability is an illusion when viewed through the lens of purchasing power and external risks.Not only will inflation steadily erode the real value of cash, but counterparty risk threatens its safety within financial institutions, and physical vulnerabilities make it susceptible to theft or loss. These risks, while different from the volatility seen in markets, can be just as damaging to your wealth over time.

What Can You Do to Mitigate These Risks?

Diversification is the key to mitigating the risks associated with cash. While it is essential to keep a portion of your portfolio in liquid assets for emergencies and short-term needs, it is equally important to invest in assets that can outpace inflation and offer growth potential. Consider including stocks, bonds, real estate, and even inflation-linked securities in your portfolio to help preserve and grow your wealth over time.Moreover, when holding cash, consider spreading it across different institutions to minimise counterparty risk. For physical cash, limit the amount you keep on hand and use secure storage options like safety deposit boxes to reduce the risk of theft or loss.While cash plays a vital role in financial planning, it is not the risk-free asset it is often perceived to be. Inflation, counterparty risk, and physical vulnerabilities are real threats that can erode its value and safety. Understanding these risks is essential to making informed decisions about how much cash to hold and where to hold it. By acknowledging and addressing these hidden dangers, you can better protect your wealth and ensure that cash serves its purpose without compromising your financial future.