“Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value.”
– Warren Buffett
Step one to a successful retirement is saving money. Step two is growing your savings faster than inflation. Step three is sufficiently growing wealth without taking undue risks.
Holding too much of your money in cash can make this process difficult for two reasons. The first reason is that cash has provided poor long-term returns. Below we compare the historical returns of stocks, bonds and cash in three different ways:
- Total Return* (price appreciation and dividends/interest)
- Real Return** (total return after inflation)
- After-Tax Real Returns*** (total return after inflation and taxes)
Bonds (green bars) do a decent job of maintaining purchasing power over time, but their primary role is to reduce overall portfolio volatility. Stocks (blue bars) are the primary asset used to grow wealth beyond the rate of inflation.
Cash (red bars) barely covers inflation and, even worse, it historically has generated a negative after-tax return. So at the end of the day, it doesn’t pay to own cash from a performance perspective.
The second problem with holding too much cash is the psychological mind games that come into play. When stocks are going up, people frequently tell themselves that they will wait for a pullback to deploy excess cash; and when stocks fall, there is an urge to wait for them to fall further.
A strategic cash buffer makes sense. The exact amount varies from person to person, but a good rule of thumb is 6-12 months of expenditures for someone that is still working and 18-24 months of expenditures for people in retirement. Different personal situations and risk tolerances dictate different cash strategies, but the real key is to have a plan that works for you and stick to it.
In an ideal world, we could meet all of our goals by simply being good savers and use safe, liquid assets such as cash. However, investors need to take risk in order to generate real returns.
*Total Return indices: Stocks are represented by the CRSP 1-10 market portfolio. Bonds are represented by five-year US Treasury Notes. Cash is represented by one-month US Treasury bills.
**Real Returns are the Total Return indices less the US Consumer Price Index.
***After-Tax, Real Return Data comes from BlackRock, Morningstar, and the Tax Foundation. Federal income tax is calculated using the historical marginal and capital gains tax rates for a single taxpayer earning $110,000 in 2014 dollars every year. This annual income is adjusted using the Consumer Price Index in order to obtain the corresponding income level for each year. Income is taxed at the appropriate federal income tax rate as it occurs. Capital gains for stocks are assessed every five years when there is a cumulative gain from the last high and assume a five-year holding period to determine the long-term capital gains rate. Bonds are assumed to be held to maturity. No state income taxes are included.
PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS. Investing involves risk. It should not be assumed that recommendations made in the future will be profitable or will equal the performance shown. Investment returns and principal value of an investment will fluctuate and losses may occur. Diversification does not ensure a profit or guarantee against a loss.