“Cash Is Not Really King”
We have all heard the saying “Cash is king,” time and again. But is it really? Cash tends to be a safe haven for investors especially in uncertain times like these, but most investors hold on to more than they need. Having too much cash can hurt your returns, force you to compromise on your goals, and potentially delay your retirement.
There is a very public and active ongoing debate out there on where the US market is headed. For the longest time, (by longest I mean around 2 months) I was in the camp that was expecting a wide U or a W shape recovery and certainly expected the market to retest the March lows. The Fed, however, has more than likely taken that option off the table. Barring a significant hiccup on the health front where we see a sharp resurgence in cases as the economy opens up here are 10 reasons why I believe regardless of where the market is headed in the short-term investors can enhance returns by putting excess cash to work.
1. Cash is a depreciating asset!
Over time, cash often loses purchasing power, which means its value is eroded by rising costs (i.e. inflation). Although inflation has been low in recent years, yields have been even lower, which means that cash has lost roughly 14% of its real spending power since 2008.
2. The opportunity costs are huge
When we choose cash over more robust investments, inflation isn’t the only concern. Too much cash means lost opportunities or returns that you could have earned if you had invested your cash. Opportunity cost can be much higher than you think.
Based on data from MorningstarDirect, a dollar deposited in a bank account in 1928 would only be worth $20 today, versus $114 if the dollar were invested in US Treasuries; $2,092 if invested in a balanced 60% stock, 40% bond portfolio; or $7,432 invested in the S&P 500. Having an adequate allocation to stocks and reducing the “drag” from excess cash are crucial steps toward achieving your long-term financial goals.
3. Inflation risk could further hurt Cash holdings
Many central banks around the globe have set interest rates at record lows. The unique challenges from COVID-19 will likely mean the interest rates will remain at low levels for even longer. In addition, central banks may be willing to accept moderately higher inflation, which would further hurt the purchasing power of cash.
4. Stocks reliably beat cash over the long term
Stocks can experience significant losses from time to time but have consistently provided solid long-term returns. Cash is very unlikely to lose much value overnight, but it is also virtually guaranteed to lose its buying power over time, given the fact cash and money market yields are incredibly low, falling below the inflation rate. This has also been true historically. Since 1928, based on data from Bloomberg, stocks have outperformed cash in 69% of 1-year periods, 84% of 10-year periods, and every single 20+ year investment horizon.
5. Bonds can help reduce portfolio losses better than cash
High-quality bonds, such as Treasuries, are a more powerful tool than cash for managing portfolio drawdowns. Unlike cash, whose value is relatively insensitive to interest rate movements, high-quality bonds usually appreciate when stocks sell-off. That’s because stock market selloffs are generally accompanied by economic slowdowns, which usually result in lower interest rates (due to central bank rate cuts, lower growth expectations, and a “flight to safety” by investors).
When interest rates fall, bond prices rise. For example, during the 34% drop in the S&P 500 from 19 February to 23 March 2020, long-duration Treasuries gained 14%, while cash returned less than 0.3%, based on data from Bloomberg.
6. Globally-diversified stocks suffer fewer losses
It can be tempting to allocate more to our home country’s market and to favor equity markets that have been outperforming more recently. But these temptations can hold significant risk, so it’s important for investors to avoid putting all of their eggs in one basket.
7. Interestingly drawdowns are less likely than many think
This is actually the most interesting observation among the 10 things listed here. Looking at monthly total returns from Bloomberg since 1945, an investment in the S&P 500 at any random time would have had a 28% probability of never falling below that level at any point in time, and only a 22% chance of ever experiencing a 20% bear market decline from that point.
8. Market timing really doesn’t work
The cost of attempting to time markets can be very high. For example, since 1960, buy-the-dip strategies—which buy opportunistically after 5% or 10% market selloffs, but sell stocks at all-time highs—would have returned just 2.5% per year, versus 10% for a simple buy-and-hold S&P 500 investment. Trying to time a balanced stock/bond portfolio would be even more difficult since their losses have historically been rarer and less acute.
9. A balanced portfolio inherently limits bear market risk
There is significant value to investing in a balanced fund that includes a healthy allocation to bonds. We call this your Asset Allocation. A balanced portfolio inherently limits bear market risk because bond returns tend to be higher during economic slowdowns and bear markets, helping to offset equity losses.
Based on MorningstarDirect data since 1945, a 60% stock, 40% bond portfolio would have experienced an average bear market drawdown of just 19.9%, versus 34.5% for an all-equity approach.
10. Investing based on your goals can help you find context and confidence, regardless of what markets are doing
One reason why investors hold excess cash is that they aren’t sure how much they will need to spend; another reason is that markets can be highly uncertain in the short-term.2