Understanding Cash Will Make You A Better And Happier Investor

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Investors have a real knack for over-thinking things.  There are those who imagine themselves as master traders controlling hundreds of variables at once like rocket scientists or professional sound mixers and squeezing out every last decimal of performance.  And of course there are inexperienced types who also imagine investing works like that but who lack the confidence to even start learning.  Personally I believe this complexity myth is disruptive to the well-being of both sets of people, and nowhere do I see this more than in the simplest of investing topics — cash.

Whenever the topic of cash comes up in portfolio discussions, I’m always a little surprised at how polarized the conversation quickly becomes.  On the one hand, the thought of losing money by buying stocks at the wrong time is too much for many potential new investors to overcome and the default response is to stay in cash.  Raise your hand if you’ve ever felt this way:

 

I keep hearing from smart people that markets are overvalued, so I’m just going to sit tight and put off investing until I’m sure I won’t lose money.

 

But on the other hand, experienced investors often view cash as a waste of resources that ignores the many potentially profitable and definitely risky things the same money can be used to purchase.  I hear some version of this argument all the time:

 

The opportunity cost for holding cash is too high.  It earns virtually nothing, and you’re guaranteed to lose money to inflation.  Just get over your fear and buy stocks!

 

So which viewpoint is correct?  Honestly — they’re both misguided.  Cash is possibly the single most misunderstood investment asset, and both perspectives lead people to conclusions that underestimate the role that smart asset allocation plays in investing success.

To explain, I think it helps to start with the definition of cash.  When people think of that word, the most common image that comes to mind is probably a stack of paper or a cartoon bag full of coins.  But if you’re seriously researching investing, the odds are very good that you do not have your life savings stuffed under the mattress or buried in the back yard.  Most people store their money in some sort of savings account, and while you may have an old-fashioned image in your head of it simply sitting in a vault let me break the news to you — you’re already an investor!  Not only that, but by putting your money in an interest-bearing account you’ve made a default portfolio selection and you just don’t realize it yet.

This is where it gets interesting, as even experienced investors often have a gross lack of awareness of how that cash portfolio behaves.  For example, let’s circle back to the very common belief that cash is guaranteed to lose money to inflation.  That’s true if you only think of cash in physical form, and the resulting portfolio looks like this.

 

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Basically, that’s a raw map of inflation with no offsetting returns, and the sea of red is indeed pretty bloody.  But cash in a savings account does not work that way, and the appropriate asset to model the historical performance of invested cash is treasury bills.  These are the very short-term interest-bearing government securities that not only drive certain cash-equivalent bond funds but also many money market accounts.  How much of a difference can that really make?  All the difference in the world.  Here’s what the inflation-adjusted return of invested cash looks like in various countries.

 

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As you can see, while there are certainly a few times when cash lost money to inflation it actually provided a small return above inflation the vast majority of the time.  And lest you think this is an isolated phenomenon, it works this way in every country and currency and even holds up in times of very high inflation.  Believe it or not, even as inflation in the US spiked well into double digits in the late 70s and early 80s, Tbills lagged inflation by more than 1% only once in that period!  Completely counter to common belief, properly invested cash is perhaps the single most consistent inflation hedge available.

That consistent performance has its benefits, and here’s a real mind-bender for US-centric investors — in Canada since 1970, the safe withdrawal rates for all retirement lengths up to 40 years with a 100% cash portfolio have been equal or superior to one with 100% stocks!

 

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At this point I imagine many of you may be very confused, as it’s a common belief today that cash is a static asset that by definition returns virtually nothing.  Well I submit that there’s a good chance you’ve been conditioned by a combination of recency bias and poor assumptions.  The number of financial calculators I’ve seen that assume a fixed low rate of return for cash always frustrate me for their glaring lack of historical context, so I don’t fault people for not understanding how cash really works.  Here’s a good image from the Federal Reserve Bank of San Francisco of the history of cash interest rates in the United States over the last half of the 20th century:

 

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There are three important takeaways from that chart and the previous heat maps:

  1. Cash is a dynamic asset and the return is not at all fixed
  2. Cash correlates quite well to inflation
  3. Cash does pretty well even in times of rising interest rates

That last point is especially important with today’s extremely low rates and a general worry that they have nowhere to go but up.  In contrast to longer-maturity bonds that are particularly harmed by rising interest rates, cash actually benefits by continuously rolling over expiring bills into new higher yielding options.  Cash is a fine asset in all investing environments.

So does that mean that fearful investors are right to just stick with cash and wait to set up a more diverse portfolio?  Not at all.  They may not be as bad off as biased investors who do not understand how cash works may believe, but that doesn’t mean they’re making the best use of their money.  As I said earlier, investing in cash is a portfolio choice.  So let’s compare a few portfolio charts.  When it comes to downside risk, which portfolio would you prefer?

 

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If you’re like most risk-averse investors who are gun-shy to start a portfolio because you fear losses, you probably rate Portfolio C as the most reassuring.  Well guess what — you didn’t pick cash.  Portfolio A is the US stock market, and Portfolio B is cash.  Looking only at these two options I totally understand the quandry, but asset allocation is about so much more than just trading safe cash for risky stocks.  Portfolio C is the Golden Butterfly, a prime example of the power of asset allocation in generating consistent risk-adjusted returns.  Compare the heat map of the Golden Butterfly to the all-cash alternative and you’ll quickly understand the benefit of starting your preferred portfolio today rather than waiting.

 

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And that’s just one example — there are many more worth exploring!

Finally, I think investors on both sides of the debate sometimes forget the fact that cash is not an all-or-nothing financial option.  I’ve long been a fan of cash in a portfolio, not only for investing reasons but also for the liquidity it provides for everyday expenses.  And luckily, I’m not the only person who has noticed its benefits.  Whether they choose Tbills or Short Term Bonds as their preferred cash vehicle, five different portfolios on the site recommend some percentage of a cash-equivalent asset.  So don’t just take my word for it — check out the writings of other authors as well.  Maybe that will be just the boost you need to finally overcome your hesitation to step beyond your current 100% cash investment and start intelligently moving your money towards a more productive long-term portfolio.  Or maybe their perspective will help you understand the diversifying power of cash to complement the stocks and bonds you already own.  Either way, you’ll be a smarter and happier investor.

Learn in earnest the many ways that the right amount of cash can benefit a portfolio, and you’ll never look at your bank account the same way again.

How much cash do you own, and why?