The 4th quarter market drop, concluding with the worst December since 1931, had many “investors” fleeing for the exits. The year closed out with several trillion sitting in cash, the most since March 2010. 1
When we think of risky asset classes, we tend to think of commodities, real estate, stocks, and even some bonds. Cash may be last on the list. Cash, however, has many inherent risks as well, but they aren’t as obvious.
First and foremost, cash is the worst performing asset class in history.2 Over long periods of time, cash has underperformed all other major asset classes. The more time you spend with a significant portion of your holdings in cash, the higher the probability your portfolio will underperform just about everything.
Second, holding cash for long periods of time practically guarantees that you will not keep up with inflation. Cash guarantees the loss of purchasing power. In essence, your cash becomes worth less and less each year as prices go up and your cash does not. Imagine you put $100,000 in the bank and earn 1% or so a year for 10 years. When you pick up your cash, you may feel pretty good. However, the 1% or so you earned did not keep up with the cost of a stamp, a suit, a candy bar, health care or education.3 You may think you made money, but you lost purchasing power.
One reason many “investors” hold cash is to time the market. They do this despite the fact that there has never been a documented, real-world study done by anyone ever showing that moving from the market to cash and back to the market repeatedly works. After all, you need to be right about when to get out, then when to get in, and do it over and over again. If you get burned just once, it can be “over” and your performance permanently affected. On the other hand, there are many real-world studies showing that moving to cash and back does not work and in fact dramatically increases the risk of loss. The Director of Research at Morningstar, a company that evaluates portfolio performance, stated that there is not a single example, ever, of a mutual fund beating the market over time by market timing. For a real world example of how harmful market timing can be, just ask anyone that went to cash in early December, scared out by rising rates, China and the U.S. leaving the negotiating table and the dreaded inverted yield curve.4 Yes, the market moves sharply down on that news. Unfortunately for those that tried to “sit it out,” the market swiftly adjusted back as the Federal Reserve changed its mind and provided guidance that it would not be raising rates after all, the U.S. and China decided it might be better to talk things through, and that inverted yield curve un-inverted itself. Oops. All kidding aside, this sort of move to cash permanently harms many investors who have spent their entire lives, working tens of thousands of hours to accumulate their savings, only to see a significant chunk of it wiped out due to poor advice, a lack of discipline, or by getting sucked into the hysterical financial media narrative of the day.
So what happens to the investors who stay invested in the broad market instead of attempting to time the market? How many of them have permanently lost money? Zero. Unfortunately, the investor graveyard is full of people who fled to cash for “safety.” When you think of the great investors of all time, like JP Morgan, Templeton, Buffet, etc., you do not find people who go in and out of the market; you find long-term investors who buy more when there is, as Templeton said, “blood in the streets.” Just ask clients of Creative Planning, for whom we did not increase their cash allocations during the recent market pullback. In fact, where appropriate, we bought more stocks while they were depressed.
Finally, many investors hold cash in the event of financial Armageddon, a situation when the stock market goes to zero or near zero and never recovers. In reality, if we live in a world where Wal-Mart, Nike, McDonalds, Google and the rest of the world’s dominant companies go down and never recover, it will likely accompany a default by the U.S. government on Treasury bonds. How can the U.S. government make its debt payments on its bonds if major U.S. companies have collapsed? Who exactly would be working and paying taxes to cover the debt payments? In this event, cash is worthless as the FDIC guarantee would essentially mean nothing. If you do not believe America’s major corporations can survive, then the natural conclusion is that the U.S. economic system itself cannot survive. In that event, cash may be the worst asset to own.
Despite all of this, Americans are currently sitting on more than 3 trillion in cash. Of course, the rush to cash started near the stock market bottom last year, at precisely the worst time.
Cash gives people comfort because it does not move around much. It is easy to understand, and it does not “go down.” But there is more to the story than that. While cash brings comfort, it does not keep up with inflation, constantly loses purchasing power, drags down long-term investment returns, and is of no value in the event of a true economic collapse. Keeping short-term reserves on hand is a good idea. Hoarding cash as a long-term investment, not so much.