Although holding a relatively small amount of cash for emergency expenses is considered prudent, holding too much above an emergency reserve can severely damage one’s investment returns. In today’s low interest rate environment, cash usually locks in negative rates of real return. Real return is the investment return achieved after accounting for the effects of inflation. Understanding what is a reasonable amount of cash to hold (and why) is an important decision when designing an investment portfolio in the context of one’s overall financial plan.
It may be difficult to remember, but as recently as 2007, money market returns were hovering around 5% per year. Let’s flash forward to the present day, where the average money market fund has returned a grand total of 0.01% year-to-date through October 31st. Even more disheartening is that the entire category has a total cumulative return of 0.26% from the beginning of 2009 through the end of 2012. With numbers like these, the days of 5% returns on cash seem to more closely resemble something out of a science fiction novel rather than something out of modern finance.
With returns like this it’s no wonder that cash holdings stand at an all-time high. Wait a second…what!? Yes, despite the nauseatingly low average returns on cash, the cash in investors’ accounts is at an all-time high. Individual investors’ cash holdings stand at a whopping $2.7 trillion. With cash rates so low now, this number is very counterintuitive. One would have to delve deep into the investor psyche to get a handle on this perplexing issue.
Currently, investors are willing to pay an extremely high price for liquidity and perceived safety. Call it a lingering hangover from the financial crisis/Great Recession that occurred from mid-2007 through mid-2009. Perhaps it has something to do with our obsession of not wanting to be wrong…or worse yet, be embarrassed. A rational market would argue for different behavior. Despite the fact that the bull market has been running for what is now more than 56 months and the economy has been expanding for nearly four and a half years, investors hold more cash now than ever.
In fact, a recent survey by the asset manager, BlackRock, found that American investors keep 48% of their investible assets in cash, 18% in equities and 7% in bonds. And most had no plans to decrease their cash holdings in the near future. The hoarding of cash is commonplace across social class, with all types of investors remaining cautious. In this same study, when asked to describe their mood, most investors used words like “pessimistic,” “nervous,” “concerned,” or even “depressed.”
Although it was easy to see the damage to one’s wealth the falling asset prices caused in late 2007 through early 2009, the adverse impact that inflation has on one’s wealth is less discernible—while still just as real. The following charts (comparing the average money market fund with the Consumer Price Index—a proxy for inflation) should help illustrate the dangers of holding cash from 2008-2012 (source: ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt):
|Year||Average Money Market||Category % change||Year||Average CPI||CPI % change|
As you can see, based on the growth of the “Money Market Index” versus the “Inflation Index,” every dollar that you’ve held in cash from 2008 through 2012 now has purchasing power of a little less than $0.94 (in 2008 dollars). This can be determined by the fact that $1.00 inflated from 2008 to 2012 has grown to $1.0664 while $1.00 in a money market is now only worth $1.0026, on average. Therefore, since 2008, one’s dollar has lost more than 6% of its buying power.
This year, the CPI is up another 1.68% through September, so the CPI index listed above is now at 108.43 which means that one’s 2008 dollar is now worth closer to $0.92 as of the 4th quarter of 2013. As mentioned earlier, holding cash was not always such a losing proposition on a real rate of return basis—the rules have obviously changed. However, the sad fact of the matter is that most investors have not changed their preferences, and are paying dearly for this mistake.
A quick example will help to illustrate this loss in purchasing power. Let’s say your favorite cereal cost $4.00 on average in 2008. Well, as of September 30, 2013, that same box of cereal now costs about $4.34. This number is derived at by taking $4.00 and multiplying it by the CPI index of 1.0843. Unfortunately, that same $4.00 in your savings or money market account has only grown to $4.01. This is calculated by taking $4.00 and multiplying it by 1.0026. So, while you were able to buy your favorite cereal with the $4.00 in 2008, that $4.00 in your bank account has only grown to $4.01 while your favorite cereal costs about $4.34. You are now $0.33 short because of the menacing effects of inflation.
Although the effects of inflation are not as noticeable as a drop in asset values, their impact on one’s purchasing power is just as real. The insidious nature of inflation is quite disturbing as it typically doesn’t happen overnight, but rather over a period of time. Inflation leaves consumers shaking their heads, as they don’t necessarily see inflation eroding their buying power. Falling asset prices are the enemy that investors know; inflation is the enemy they can’t see.
We view cash as the most dangerous “investment” you can own. Investment is in quotes as we don’t really look at cash as an investment. Based on current prevailing interest rates, keeping your hard earned money in cash locks in a negative real rate of return. Depending on your circumstances, the prudent rule of thumb is to keep 3-6 months of living expenses as well as any upcoming known cash needs in a liquid savings account, such as a money market. Anything above and beyond that should be considered inefficient at best and can even be viewed as hoarding behavior in extreme circumstances.