You Can Lose Money in Cash

“Stocks are the thing to own over time. Productivity will increase and stocks will increase with it. There are only a few things you can do wrong. One is to buy or sell at the wrong time. Paying high fees is the other way to get killed. The best way to avoid both of these is to buy a low-cost index fund, and buy it over time. Be greedy when others are fearful and fearful when others are greedy, but don’t think you can outsmart the market.” – Warren Buffett

Common sense reader mailbag: Why can’t I just keep all of my investments in a savings account? I earn some interest and I will never lose money.

I have run into a few very risk averse long-term investors over the years. Most of them can’t handle the short-term price swings in stocks so they have a heavy weighting to bonds in their portfolio.

This makes sense for those that don’t have the willingness, ability or need to take risks in the stock market.

But keeping all of your investments in cash takes risk aversion to a whole new level (to me cash is simply savings accounts or money market funds).

And I can understand why some investors get nervous just thinking about investing in the markets when there is so much uncertainty that we are forced to deal with.

It is true that you will never see the value of your investments decrease if you hold all of your money in cash. You take away the risk of volatility and large losses in the short-term. But you open yourself up to other risks by taking this investment stance.

You run the risk of not achieving your long-term goals unless you save an enormous amount of your earnings. Even then you may technically lose out over the long-term. Take a look at this chart from BlackRock that shows the long-term returns for stocks, bonds and cash along with the performance net of inflation and after-taxes and inflation:

You can see that although cash may feel safe to you in shorter time frames, over the long-term you can actually lose purchasing power after accounting for inflation and taxes. Here is Cullen Roche, from Pragmatic Capitalism on this subject:

If you leave 100% of your savings in cash you are guaranteed to lose about 3.5% on average just from the loss of purchasing power (that’s the average CPI since 1925).  The best way to protect against this is to get in the asset diversification game and start owning assets that will help you protect your money against this loss of purchasing power.

Contrary to popular mythology, a portfolio doesn’t really have to beat the S&P 500.  It also doesn’t have to compete with hedge funds or Warren Buffett or anyone really.  In fact, it doesn’t have to do half of the things that Wall Street says it needs to do.  But it really does need to keep pace with purchasing power or you’re falling behind just by doing nothing or misunderstand this most basic point. 

This is why cash should be considered an asset but not an investment. Holding cash can be very helpful over the short-term. You can use it to dollar cost average into the market or buy undervalued investments when markets fall.

You also need cash when you have near-term spending needs. In fact, I would urge you to keep enough in your savings account to cover a few months’ worth of expenses in the case of an emergency.

Having that cash for unexpected expenses, a vacation, house down payment or whatever you need it for can be very helpful to you in the short-term. Cash can be a great asset because you know you don’t have to worry about the loss of principal if you need to use it. Stocks and bonds don’t off that same kind of protection.

But as an investment cash leaves much to be desired. Stocks and bonds must play a role in your portfolio to have any shot at growing your wealth over the long-term.

IGNORE THE NOISE
Since you are so worried about seeing losses in your investments, you need to change how you view your time horizon. One way you can overcome this nervousness is by simply ignoring your portfolio over the short-term.

Take a look at the data set below from Ken Fisher of Fisher Investments. This table shows the number of times from 1928 until June of 2012 that the S&P 500 was positive or negative based on different time horizons:

Daily returns are basically a flip of the coin between stocks either rising or falling. But as you go further out you can see that the longer your time horizon the lower your chances of loss have been in stocks.

You can’t forget about your investments forever because you will need to update your investment plan as your circumstances change and rebalance to stay disciplined. Checking once a year will probably suffice.

But ignoring the short-term noise in your portfolio can help you stay on track without completely losing it when you have periodic losses in stocks or bonds.

Other investors that can handle short-term volatility will be able to check in on their investments more often. But for those without the intestinal fortitude, it will probably make sense to forget about your investments most of the time.

Your returns won’t increase based on the number of times you check the value of your portfolio. In fact, they will probably decrease because it could cause you to take unnecessary actions.

IN SUMMARY

• Cash is an asset, but not an investment.
• Cash barely keeps up with inflation and is a loser after taxes.
• Stocks increase your chances of building wealth even if they can go down from time to time.
• Your odds of success increase as your time horizon increases.
• Ignore your investments over the short-term to save yourself from unwanted stress.
• Inaction can be a good thing as long as you continue to save and invest.
• Check your balances and goals once a year to make any necessary changes.

Sources:
BlackRock
The Little Book of Market Myths
Pragmatic Capitalism

Further Reading:
How do you earn higher rates on a savings account?

I wrote a guest post about some common misconceptions on the stock market for Mark at My Own Advisor this week so please check it out: Stock Market Myths

Plenty of interesting stuff I’ve been reading this week. Enjoy:

• A Portfolio that’s as Simple as One, Two, Three (WSJ)
• This Man Will Make You Rich – An Interview with John Bogle (Men’s Health)
• Why the Long Bias? (Reformed Broker)
• 4 Mistakes That Make Everyone a Bad Investor (Motley Fool)
• There is No Such Thing as Emotionless Investing (Abnormal Returns)
• More Lies about Active Management (Index Universe)
• How Driverless Cars Could Reshape Cities (NY Times)
• A Dozen Things I’ve Learned From Michael Mauboussin About Investing (25iq)
• Ignore the Experts and Switch Off Your TV (MoneyWeek)
• Lessons Learned From Well Behaved Investors (NY Times)
• Many Will Not Retire; What About You? (Aleph Blog)
• 10 Biggest Box Office Bombs of All-Time (AMOG)
• Invest Like a Chicken (Rick Ferri)
• Buy High Dividend-Paying Stocks, Hold for a Year, Rebalance, Outperform the Market (Businessweek)

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