7 things you should know about cash
Reprinted courtesy of MarketWatch.com.
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Cold, hard cash. Money in the bank. Cash is king! What’s not to like about the green stuff?
This is a tricky topic. We all love cash, and in some ways, you can’t ever have too much of it … except when you can.
Let’s start this discussion with the premise that cash is not a good investment. It won’t help you grow your wealth. On the contrary (because of inflation), cash is practically guaranteed to leave you with a loss of purchasing power.
To help you contemplate your cash, here are seven interesting aspects of cash.
1. Cash is like comfort food. It makes us feel good; it makes us feel secure. Sometimes cash gives us financial bragging rights. For example, some investors were lucky enough to have most of their investments in cash in 2008, when many of their friends were enduring portfolio losses of 20%-40%.
However, if you’re still sitting on cash as the result of selling equities back in 2008 and 2009, you’re not doing yourself any favors. I recommend you get back into the market using dollar-cost-averaging to avoid buying everything at what might later turn out to have been the most expensive prices.
2. Sometimes holding significant amounts of cash makes good sense as an investment. About half of my own retirement investments are professionally managed using several mechanical market-timing systems.
When a timing system dictates being out of equities, cash is a very safe and convenient place to be on the sidelines until the system indicates it’s time to buy once again.
However, I don’t think more than one out of 100 investors can successfully deal with the emotions of timing.
3. Sometimes the biggest hoarders of cash are too timid. What does this mean? They refuse to take even the relatively small risks of investing a modest 20% to 30% of their portfolios in equities. Such people are failing to make financial markets work on their behalf. Their short-term comfort may cost them the comforts of retirement that they would otherwise have … and might cost their kids or other heirs huge sums of potential dollars.
4. Over the long haul, cash is a lousy investment. Over an investment lifetime (or during your retirement), cash has the greatest risk of loss (pretty much guaranteed, in fact) of any major asset class. Over the past 40 years, since 1976, the purchasing power of $1 million declined to about $236,000, thanks to the compound effects of 3.7% inflation.
During that same 40 years, Treasury bills, which are essentially risk-free, increased their purchasing power by 1.1% a year. That’s vastly better than cash, though certainly not enough to build a meaningful retirement fund.
5. Because cash earns no income and gradually loses its value, I take a dim view of using it for an emergency fund. You won’t go wrong following my emergency-fund recommendations at Vanguard. But there are plenty of alternatives, and I think the topic deserves a little discussion
When I was an investment advisor, I often recommended that emergency money be held in a combination of the Vanguard Wellesley Fund and a no-load short-term bond fund.
According to Morningstar, for the past 15 years, the Vanguard Short Term Investment Grade Bond Fund has compounded at 3.7%. This isn’t risk-free, of course. In 2008, this fund lost 4.7%. But in 2009, it gained 14% (a performance that’s unlikely to be repeated). In 2013, this fund had a gain of 1%, which I regard as more normal.
I have a longtime friend who has a slightly different take on emergency funds. He believes some things that often pass for emergencies are really the result of a lack of planning or the absence of a “rainy-day fund.”
Here’s his view:
“A true emergency is unlikely to occur more than once or twice a year; in fact, you may go for years between emergencies.
“However inconvenient it may be, a rainy day is not an emergency. So keep some reserves on hand for the unexpected, and don’t confuse the breakdown of your washing machine (which is utterly predictable except for the timing) with an emergency.”
My friend keeps his emergency money in a balanced fund that holds both stocks and bonds. This gives him quick access to money when it’s needed, it gives him a good probability of obtaining at least modest growth, and it keeps his risk at a level he’s comfortable with.
6. If you have sufficient cash reserves, you can use them as a bank. What this means is that you can essentially borrow from yourself when it makes sense. Here’s an example:
Assume that your emergency fund is adequate and you are contributing money each month to fund an IRA. You could borrow your entire year’s IRA contribution from your emergency fund, make the investment at the start of the year, then replenish your emergency reserves monthly with the money you would have otherwise contributed piecemeal to your IRA.
7. Money (especially cash) burns a hole in some people’s pockets. You should be wary of this. You probably already know your own reaction — and that of your spouse — to having much more than usual in your bank account. Personally, I don’t know that my spending pattern changes very much with the ups and downs in my bank balance.
But if the temptation of lots of cash is a potential problem for you, then you probably don’t want six months’ worth of spending power — or even three months, for that matter — sitting in your checking account.
To make it slightly harder to get at it, you can put extra dollars in a savings account that you set up so you must make a phone call or go to the bank to get your money. Alternatively, if you hold cash in a 30-day certificate of deposit (CD), you’ll earn a little interest and have an incentive to leave it there until the CD matures.
I also suggest that you remember this cash-burns-a-hole-in-the-pocket tendency whenever you are thinking about giving significant amounts of cash to a child or a grandchild.
For example, if you’re giving somebody money to help with a year’s worth of living expenses, you might want to dole it out a month at a time instead of giving them the whole amount in January and expecting some of it will still be there for November and December.
These seven points should give you plenty to think about.
For more thoughts on your money and investments, check out my latest podcast, which includes my “outrage of the week” and answers to 11 questions from readers.
Richard Buck contributed to this article.