Why You Shouldn’t Hold Cash in Your Portfolio
At times, things that people believe provide safety and stability can actually do more harm than good. For example, training wheels may help you balance on a bicycle, but on a long-distance trek they can slow your pace and increase the risk of injury.
When investing, cash can have a similar effect on your portfolio. While cash seems like the safest investment, in the long run it can drag down your portfolio and hurt your ability to reach your financial goals. Here’s why:
1. Low returns
As generally low-risk investments, cash investments are expected to earn low returns. According to a 2013 Vanguard report, the nominal (before inflation) historical average for cash from 1926 –2012 was 3.7%, compared to 9.9% and 5.5% for stocks and bonds, respectively. Especially in a low rate environment, cash likely won’t generate the returns needed for your long-term financial goals.
2. Inflation risk
Because of low returns, cash is vulnerable to inflation risk. The median inflation rate from 1950 – 2012 was 3.1%. Thus, cash on average nearly generated negative real returns. While cash may not decline in a market downturn, it also may not provide the capital preservation people assume as inflation reduces buying power.
3. Opportunity cost
Cash in your portfolio means less capital invested in other investments. This impacts your exposure to the long-term growth of asset classes such as stocks and bonds that have historically earned returns greater than inflation.
4. Market timing is difficult
A common argument for holding cash is to have reserves available to take advantage of perceived market opportunities. One problem with that strategy is that it requires you to successfully pick the right investment at the right time, which is extremely difficult. Consider that large market jumps typically happen on a few days, making them nearly impossible to predict. Missing the best market days can reduce your portfolio’s ending balance.
Another problem is the challenge to overcome your emotions. After a significant market drop, most investors lack the fortitude to pull the trigger and buy when everyone else is panicking.
Instead, stick with a strategic asset allocation, sans cash, for the long term. When you are fully invested, cash won’t drag you down during market recoveries. Additionally, you can take advantage of market opportunities by rebalancing your portfolio. As your asset allocation shifts from market swings, you’ll be able to tell what’s expensive and what’s cheap. Selling some of what has gone up and buying some of what has gone down to return your assets to their original target levels is a way to unemotionally buy low and sell high.
Ultimately, hold cash in a separate savings account for your short-term needs. Meantime, use your portfolio to hold investments that can be used to raise cash to replenish that savings account.
For insight on how to raise cash from your portfolio, watch this short video: Generating an Income Stream from Your Portfolio.