Why Holding Cash May Be Comfortable But Counterproductive

04/20/2022

With the uncertainty and market swings of the past few years, it's understandable that some investors would seek the safety of cash. On the surface, holding cash means not having to cope with the ups and downs of the stock market due to the pandemic, global conflicts, rising interest rates, the Fed, and more.

However, this is only true over the shortest of timespans. Over months, years and decades, the value of cash is quietly eroded by inflation, and the missed opportunities of not being properly invested can add up. This is why, for long-term investors, managing behaviour and emotions is just as important as managing portfolios. Doing so helps investors stay on track to achieve their financial goals, while helping them to sleep well at night too. ​ There are three main problems with sitting on cash today.

First, high inflation - the worst in four decades - is eroding the value of cash, especially when it sits in a savings account. By not earning a sufficient level of interest or generating a return, the purchasing power of one's hard-earned money falls each year. Energy costs have increased more than 25% over the past year, food price nearly 8%, medical care services 2.4%, and so on. Even as inflation rates settle down, this corrosive effect will no doubt continue. This is the hidden cost when investors seek the safety of cash. The balance on a bank statement may feel safe since it is stable, unlike the fluctuating value in an investment account. However, what matters isn't the amount of cash but what it can purchase. Inflation means that the same number of euros buys fewer goods and services each year, even when the number remains the same. Thus, portfolio growth is needed to keep an investor's purchasing power at par, let alone to create real wealth. ​

The second problem is that cash and savings accounts still generate little to no income, even with medium and long-term interest rates rising. The rate for a stashing 12 months cash in your savings account is still only 0.50%. In other words, locking up €1,000 of cash for 12-months would only yield €5 when inflation would have eroded its spending power by €80. In this example, the real inflation-adjusted rate is what matters. Additionally, government-issued bonds with the shortest maturities still yield very little relative to long-term rates, and it will take time for savings accounts to catch up. ​The picture is very different for fixed income bonds that generate between 7% to 10% per year. This is why it may be important to build a portfolio using diversification, fixed income bonds laddering, and other tools, ideally with the support of a trusted advisor. ​

Third, for those saving and investing to achieve financial goals, shifting a portfolio to cash may provide short-term comfort but will most likely jeopardise long-term gains. Finding the right balance between resisting the urge to react to short-term news, while taking advantage of the long-run growth of the market, is the biggest challenge all investors face. ​ For investors, cash is simply another asset class with particular characteristics that can be combined with stocks, fixed income bonds, alternatives, and more. The right mix that takes advantage of all asset classes can achieve a much better balance of risk and reward. This is the preferred way to manage portfolios leading up to and through retirement while improving investor confidence and avoiding the urge to time the market. ​ Ultimately, cash is an important part of any portfolio if used appropriately and in moderation. Having the discipline to save enough cash in the first place is the first step toward financial freedom. Investing that cash in the right portfolio is what grows savings into real wealth.

For investors who prefer cash to protect their portfolios, holding diversified assets is often a much better approach for long-term appreciation. Not only does this protect investors on the downside, but it helps to generate long-run growth. ​ ​The bottom line? While cash can be alluring, rising inflation means that staying diversified with more attractive fixed income bonds is likely to be a better approach. Consider keeping enough cash necessary in reserves, but having too much cash can hurt your long-term success.

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