Why Cash May Not Be As Safe As You Think

This article was written with Jim Cahn, the Chief Investment Officer at Wealth Enhancement Group. It was part of a series of articles developed under an agreement with Forbes to work with a variety of contributors and assist them in delivering actionable investment ideas each week. The site forbes.com is one of the top 500 sites in the world with nearly 10 million subscribers and nearly 100 million page views a month.

Are you one of the millions of investors holding larger than normal amounts of cash for safety? If you are, you likely don’t have the right facts about cash or the markets. Keeping the bulk of your savings in cash may be not the safe harbor you think it is. It may be surprising to some, but if your primary goal is to preserve your wealth, I contend investing and being exposed to the markets may actually be a better option than keeping your money in cash in the long term.

From 2004-2013, cash had the second-worst performance out of the 10 major asset classes, according to JP Morgan. Only highly volatile commodities performed worse. Even emerging markets, with their volatility and their collapse in 2008, outperformed cash over the 10 years cumulatively by 180.7%.

I believe cash’s sub-par return performance, relative to other investment options, will continue. According to Bloomberg, from 2004 through 2008, the good years, you would have been paid an average of 3.963% for holding a 1-year CD. Today, if you buy a 1-year CD it pays a mere 0.518%. The threshold for assets other than cash to outperform is very low.

That’s not including the other risk to holding cash: inflation. While inflation isn’t the concern yet, we expect prices to continue to rise. In other words, what you have in the bank today will buy you less tomorrow.

The Value of Diversification

Given the poor historical performance and outlook for cash, it’s surprising that about one-fifth of all high net worth individuals (with $3 million or more in investable assets) are holding more than 25% of their portfolio in cash, according to a recent US Trust study.

I often ask clients and prospects why they hold so much cash.  The answer, almost always, is tied to uncertainty about the markets, especially with stocks at or near all-time highs.

I don’t think the world is all that uncertain compared to the past. Warren Buffett bought his first stock in 1942 after a decade of depression and during a war in Europe. There’s a message in the fact that one of the world’s greatest investors chose stocks over cash at a period when uncertainty was highly certain! 72 years later Buffet still choses just about any other investment other than cash.

“The one thing I will tell you is the worst investment you can have is cash,” Buffett is quoted as saying. “Everybody is talking about cash being king and that sort of thing. Cash is going to become worthless over time. But good businesses are going to become worth more over time.”

Like Buffett, we believe being invested is actually a better option for those with a longer-term horizon. Over the last 10 years, cash only outperformed a well-diversified portfolio once, in 2008 (Source: JP Morgan Guide to Retirement 2014).

Including Cash in a Diversified Portfolio

I’m not saying you should avoid cash entirely; how much cash you should keep on hand depends on your unique circumstances.

If you are married and both spouses are working in different fields, then you should keep cash on hand to cover roughly three months of your normal expenses (diversity in job sectors is a good thing too). If both spouses work in the same field, if only one spouse works, or if you’re single, then you should keep six months’ expenses on hand.

Exactly in which instruments you choose to hold your cash is a complex decision and should be decided with your financial advisor. Whether you invest inside a CD, cash equivalents or fund a Roth IRA (since you can always access the contribution amount), there are pros and cons to each option. If you have to decide without a planner, I would consider a diversity of cash instruments. That way, no matter how humble your situation becomes, you know you’ve got it on hand if you need it.

Just remember: Don’t let a single-minded focus on cash obscure the benefits of diversification, which is the real king.

— There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

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