Oran Hall | Choosing between safe and high-yielding money

There is a sharp contrast between holders of money who put priority on the safety of their money and those who favour high returns. The primary difference between them is the level of risk they are prepared to take.

The risk averse put priority on safety of capital but must expect a lower rate of return: the risk taker places priority on high returns to compensate for the higher risk. Safety of capital, though, is more about nominal capital, which is the face value of the money, and is different from its real value – its value after adjusting for inflation. One holder of money prefers the safety of money, the other the potential for a real return, the advantage of which is the ability of money to retain its purchasing power.

The American actor, columnist and humourous social commentator, Will Rogers, has often been credited with the following quotation: I am not as much concerned about the return on my money as the return of my money. This expresses very well the thinking of the risk averse who are comforted by being assured that their money is secure.

People who make safety of principal their priority tend to opt for savings accounts, money market instruments, and money market managed funds. In extreme cases, some opt to keep their money ‘under the mattress’, in which case, the money does not find its way into a financial institution. But, is such money really safe?

The safety of money in banking or deposit-taking institutions – commercial banks, merchant banks, and building societies – rests on the strength of the institutions. Being highly regulated by the Bank of Jamaica, BOJ, the risks are quite low. Lessons have been learned well from the financial sector crisis of the 1990s when many buckled under high interest rates. Incidentally, it was the weaker institutions which paid the highest rates in order to attract deposits.

The risk of losing money in the banking system is significantly reduced – perhaps eliminated – by the Jamaica Deposit Insurance Corporation, JDIC, which insures deposits of their policyholders. In the event that a bank is unable to return deposits to its depositors, it uses its deposit insurance fund to pay the amount in the account up to $1.2 million per depositor, per financial institution, per each account ownership category.

Beyond this, depositors can get more coverage by each family member having an account, family members having joint accounts in addition to their personal account, setting up a trust account in a child’s name, having a business account and a personal account, and a nominee account in which a beneficiary is designated to receive the funds upon the death of the account holder. Because there is a limit on how much compensation depositors can get through the JDIC, they still risk losing some of their funds in the banks.

Money market instruments include interest-earning instruments that mature in 365 days or less, and pooled investment funds such as unit trusts and mutual funds which invest primarily in money market instruments. The dominant money market instruments, such as Treasury bills and certificates of deposit, are issued by the Bank of Jamaica.

Additionally, there are repurchase agreements, many of which are issued against BOJ instruments. These instruments are generally quite safe. A close look at money market funds in the pooled funds suggests that money market instruments account for less than 100% of the value of the portfolios, which explains why some perform below expectations as market conditions may cause the price of some instruments to decline.

‘Money under the mattress’ is not as safe as some believe. Loss may result from theft and disasters such as fire, and, even if that does not happen, it yields no income.

There are, however, situations in which it makes sense to hold cash. For instance, in periods of uncertainty, it is best to hold cash for a while, if necessary, until the market settles down, or to place funds for very short periods.

The degree of safety offered by instruments giving higher returns depends on the quality of the instruments and market conditions. The quality of debt instruments like bonds depends on the financial strength of the issuer – and this can vary widely.

Additionally, while the sum invested is generally returned at maturity, selling prior to maturity may cause loss of capital if interest rates increase after the investment is made.

Instruments that offer capital appreciation, equities and collective investment schemes that invest in them, for example, while promising good returns especially in the long term, may yield significant losses because of the poor performance of the companies or poor market conditions, which can be protracted at times.

What comes as a surprise is the willingness of some individuals primarily concerned with safety of principal to dive into the stock market when it is experiencing a bull run and into Ponzi schemes; the pull of the herd can be very strong.

People concerned about return on their money look to capital gains and higher income. People concerned about return of their money earn less income for their risk aversion, but can enhance their returns in two ways: using the power of compounding, whereby they keep their funds saved or invested for a long time and re-investing the income, and by seizing opportunities to earn tax-free income.

Oran A. Hall, author of Understanding Investments and principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel. finviser.jm@gmail.com