Keeping a lot of cash on hand is a poor investment strategy

By Brent Lindell

A trend the financial industry has noticed lately is that many investors have accumulated larger than appropriate cash levels. Cash includes money market accounts, checking accounts, saving accounts, T-bills and CDs. Typically, such investments are best used for short-term liquidity and emergency purposes. An investor should keep some cash on hand to pay taxes when they are due, replace the refrigerator if it goes out or take a trip on a whim.

Financial advisers think the larger balances seem to suggest that people are now either more complacent, more anxious about liquidity and markets, or have simply forgotten that cash is not designed to make money. In fact, at current interest rates, yields are typically less than 1 percent. CDs pay only slightly more. When taking into account that inflation averages about 3 percent over time and taxes need be paid on the 1 percent interest, these cash vehicles are guaranteed to lose money after taxes and inflation. So much for cash being low risk!

If you have a lot of cash around, reassess how much is really needed. We suspect the main reason people have hoarded cash in recent years is that the market has been frustrating and scary. Instead of investing annual bonuses, excess cash flow and the proceeds from matured CDs, the cash ends up sitting dead in the water.

We know … at least you didn’t lose money in cash! But while cash might have felt good when the market was in decline, it’s a big drag now that the market is seemingly in recovery. Thus, if you are a cash-rich investor, you are incurring a significant long-term opportunity cost.

Imagine that instead of holding a reasonable $5,000 cash, an investor instead accumulates and holds $25,000. While this does not seem like a big deal, the lost return adds up over time.

For example, if a long-term portfolio averages 8 percent a year, versus 1 percent on cash, the $25,000 in cash costs you about $1,750 a year ($25,000 x (8% – 1%)). Over 10 and 30 years, the cost compounds to a much larger $24,178 and $165,306.

Maybe sleeping better at night knowing you have $25,000 under your pillow is worth it. On the other hand, the forgone earnings could alternatively pay for a vacation, buy a couple cases of world-class wine, increase charitable donations, pay for better Christmas presents, buy jewelry or pay for 20 more dinners per year at nice restaurants. And, if investors instead accumulated the growth each year, they might eventually retire early and/or set up a charitable foundation!

How much cash is enough? If an individual has a taxable investment account and owns bonds, he or she probably doesn’t need a lot of cash, since long-term investment accounts can always be accessed with a little notice. Home equity and credit cards can also be used in a real emergency, but the suggested amount is enough to cover your expenses for three to six months.

Bottom line: Don’t hoard more in cash than you really need for short-term liquidity and emergencies.
 

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