Cash—such as money stowed away in bank accounts and money market funds—isn’t the most glamorous investment. Its value doesn’t fluctuate on a daily basis like stocks do, and (especially in the low interest rate environment of the last few years) it doesn’t grow much over time. Yet having the right amount of cash is an important factor in achieving your financial goals.
A common mistake is to have too much cash, whether out of fear of the ups and downs of financial markets or just because you never got around to putting it into other investments. Holding a lot of cash can make your portfolio seem “safer” by limiting the amount that its value bounces up and down on a daily basis. But over the longer term cash investments are likely to gain far less than other assets, such as stocks and bonds. The return on cash may not even keep up with the inflation rate, let alone grow enough to meet your financial goals.
Too little cash can also be a problem, and there are good reasons not to allocate all of your money to more volatile investments. Financial planners generally recommend keeping about six months’ worth of your typical expenses in cash as a buffer in the case of an emergency, such as losing your job or unexpected medical expenses. And if you have short-term financial goals, such as large expenses that you’re going to incur in the next year, keeping this money in cash helps ensure that your ability to make the payments isn’t dictated by the whims of financial markets.
It’s therefore important to have enough cash to fund your short-term needs but not so much cash that it stunts your portfolio’s potential growth. Getting this balancing act right can give you both peace of mind and the best chance of reaching your financial goals.
According to a survey by MFS Investment Management, investors on average have 24% of their portfolio in cash. Is having so much cash a good idea?
Cash is a unique investment: unlike stocks or bonds, you can use it to buy goods or pay your bills. And most cash-like investments (such as savings accounts at banks or money market funds) have very little risk since they promise to at least maintain the value of the investment. In some cases, such as with cash in US bank accounts below $250,000, this guarantee is explicitly backed by the US government.
The downside of cash is that because it is low-risk, it also tends to offer lower potential returns. After all, if other investments didn’t offer the possibility of better returns, everyone would simply keep their money in cash.
Therefore, for investors with longer time horizons, having a large allocation to cash can substantially reduce how much their portfolio is able to grow. According to data compiled by New York University professor Aswath Damodaran, $100 invested in 1928 in the S&P 500 index of large US stocks would have grown to over $250,000 by the end of 2013, compared with less than $2,000 for an investment in cash. The difference is even more dramatic after taking into account inflation, which would have eaten up two-thirds of the growth of the cash investment. And there wasn’t a single 20-year period during that span where cash outperformed the US stocks, let alone a more diversified portfolio of multiple asset classes.
That doesn’t mean investors should never hold any cash. If you have sizable near-term expenses, keeping a portion of your portfolio in a very low-risk investment such as cash can help ensure you’ll have enough money when the expenses come due. And if you’re worried that many other asset classes are going to perform poorly in the near future, temporarily increasing your allocation to cash is one way to reduce the amount of risk you’re taking. Maintaining a large allocation to cash for an extended period of time, however, it likely to limit the growth of your portfolio.