This article was contributed to us by Endowus.
We rarely hear any warnings about playing it safe. We don’t see headlines that say: “Hoarding cash forces family to file for bankruptcy”, or “Placing deposits wipes out retirement savings.” The only news we read about is how someone lost all his money investing in the Enrons, LionGolds or Hyfluxes of the world. It’s no wonder we all want to play it safe and hold cash. A Blackrock survey conducted in 2017 found that Singaporeans hold almost half (47%) of their savings in cash.
But the truth is, there are dangers to playing it safe. They just aren’t as obvious or dramatic. Cash rarely performs negatively (unless you’re in a negative interest rate environment), but this doesn’t mean that the value of cash will remain constant over time. If your cash deposits are yielding ~1%, you’re losing purchasing power every year due to inflation. Holding a sizable portion of your portfolio in cash will cost you over the long-term.
In his annual letter to shareholders in 2014, Warren Buffett explained how cash is actually a riskier investment than equities for the long-term investor. During the five decades from 1964 to 2014, the S&P returned 11,196% including reinvested dividends. In the same timeframe, the purchasing power of a dollar declined by 87%, which meant that it took $1 to buy in 2014 what could be bought for 13 cents in 1965.
As Buffett says, for the majority of investors with multi-decade horizons, short-term market moves are unimportant. The “focus should remain on attaining significant gains in purchasing power over their investing lifetime.”
Investing is a tool to help us reach our goals, and there is a target real rate of return our portfolios need to earn in order to achieve these goals. The higher the percentage of cash you hold in your portfolio, the greater the risk you need to take in your investments to hit that target rate of returns. With cash yielding close to zero, it is a significant drag on your overall portfolio returns.
If you start with $100,000 and want to double your money in 10 years, these are the returns you would need to achieve:
0% cash / 100% investments: 7.2% annualised returns on investments
20% cash / 80% investments: 9.6% annualised returns on investments
40% cash / 60% investments: 12.8% annualised returns on investments
60% cash / 40% investments: 17.5% annualised returns on investments
80% cash / 20% investments: 25.9% annualised returns on investments
The market gyrations may want to send you running to hide your cash under your mattress, but investing is a long-term strategy. We don’t know what will happen with the markets tomorrow, or the next month, or year. What we do know is that equities will almost certainly outperform cash over the next decade, and probably by a significant amount. If risk is defined as permanent loss of capital, then we’re not playing it safe by holding cash, we’re just exposing ourselves to a different type of risk – inflation risk.
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