• Investing & Markets

How Cash Can Negatively Impact Your Portfolio

June 22, 2017 | Michelle Brownstein, CFP®

There’s a common saying that cash is king – but this isn’t necessarily true when it comes to your portfolio and long-term financial goals. People tend to like cash because it can feel safe – however, over the long term, it is anything but a safe place to keep your investments. Oftentimes, investors hoard cash when they are nervous about market volatility and uncertainty. Some investors who haven’t yet invested cash may also feel like they have missed the boat after many positive stock market years and don’t feel comfortable investing it now. But the truth is, if you want your long-term financial strategy to sustain you for the rest of your life, cash is likely going to do more harm than good.

The Time & Place for Cash

That being said, cash isn’t all bad; it has a place in any strategy. That place, however, should be for any short-to-mid-term liquidity needs. We generally recommend that you keep an emergency fund of three-to-six months of expenses along with cash for any larger purchases you have planned in the next 18-24 months.

One way to be strategic about your emergency fund is to be disciplined about it. For example, if you spend $100,000 per year, you will want to have somewhere between $25,000 and $50,000 in cash reserves that you don’t touch, unless it’s a true emergency. Once you hit the maximum amount you’ve set for yourself in those reserves, then commit to putting any excess over it to work in a diversified investment portfolio. This way, you likely won’t end up with so much cash that it actually works against you.

In addition, you will likely want to keep cash for any big expenses or purchases that may be coming down the pipeline, such as a wedding or a new house or a large renovation project. And even these types of expenses provide an opportunity to put your money to work in more effective ways than cash. For instance, if you know you will likely buy a house in the next five years, you can consider investing that portion of your portfolio conservatively, such as in short-term bonds rather than stocks.

[Use our free Retirement Planner to track your retirement readiness and anticipate any big expenses]

Why Cash is Bad for Your Portfolio

Cash might give you a sense of security when you are worried about market uncertainty, but believing cash is a good long-term investment is a mistake. By holding too much cash, you are essentially losing money to inflation every year. In the past 10 years, cash has never been the best performing asset class in a full calendar year; notably even in 2008, government bonds and gold did dramatically better than cash. The chart below compares the long-term historical performance of a variety of asset class returns. Note that cash ranks the lowest.

Long-term historical performance of asset classes

Source: Personal Capital Investment Methodology

Cash Holdings Example

One very simplified example of how cash can negatively impact your long-term financial plan examines two people – J.D. and Jade both have $200,000 in assets. J.D. invests $150,000 of his assets and holds $50,000 in cash. Jade, on the other hand, invests $100,000 and holds $100,000 in cash. If we assume straight line growth with a 4% real interest rate (7% growth in moderate investment portfolio minus a 3% inflation rate), then over a period of 30 years, J.D. can end up with over $100,000 more than Jade.

Year Person 1 Cash Person 1 Investments Person 1 Total Person 2 Cash Person 2 Investments Person 2 Total Difference in Total
0 $50,000 $150,000 $200,000 $100,000 $100,000 $200,000 $0
10 $50,000 $222,037 $272,037 $100,000 $148,024 $248,024 ($24,012)
20 $50,000 $328,668 $378,668 $100,000 $219,112 $319,112 ($59,556)
30 $50,000 $486,510 $536,510 $100,000 $324,340 $424,340 ($112,170)

The Takeaway

There are times to hold cash, specifically for short-term purchases and emergencies. But, if you’re planning for the long term when it comes to your money and you’re trying to grow it, there’s almost no reason to be in excess cash. For most people, maintaining a large allocation of cash is simply a guaranteed lose.

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