Our recent Global Investor Pulse survey found that investors are holding less cash today than they were in the latter half of 2016. But, on average, they still have 58% of their money in what has essentially been a “returnless” asset since the 2008 financial crisis.
In my third post on our findings, I’ll address the nervous investor who needs growth for retirement, but instead allows fear of the markets to rule, opting to keep too much savings parked in cash.
Four things can happen when you hold excess cash with today’s yields—and three of them are bad.
In investing, the concept of “no pain, no gain” boils down to the common risk/reward tradeoff. To target higher return, you have to take on some higher degree of risk. The equity “risk premium” is the rate of return investors theoretically expect for holding stocks instead of leaving their money in the bank, where its value won’t fluctuate.
A lot goes into this calculation, and it fluctuates, but over the past few decades it has averaged about 4%. This suggests that you would expect to earn about 4% more per year owning stocks versus sitting in cash at the “risk-free rate.”
Stocks 3, Cash 1
If we use that historic average risk premium to guide our expectation of what stocks could potentially deliver relative to cash, there are four possible outcomes:
- Stocks actually do provide 4% above cash. Owning stocks instead of cash wins.
- Stocks deliver more than 4% above cash. Stocks win again. Big time.
- Stocks deliver less than 4% above cash, but out-earn it nonetheless. Stocks still win.
- Cash outperforms stocks. This is the only scenario where the bet on cash wins.
Of the four potential outcomes, only one is good for the investor who chooses cash over stocks.
Framed another way, consider a marathon race between me and world record holder Dennis Kimetto. If Dennis has a great day, an average day, or even a subpar day, he’s going to beat me. The only way I could win that race is if Dennis falls down… and stays down. So the question is, given those potential outcomes, would you rather bet on me or on Dennis?
Stocks will lose sometimes
This is not to ignore the fact that most investors aren’t exclusively choosing either stocks or cash, or the fact that stocks have been on an extended run. We intentionally focus on stocks here to highlight the investment that typically stands to lose the most during bad times, and thus, the holding that usually makes investors the most nervous.
While most retirement portfolios tend to be better diversified, stocks are typically the largest driver of long-term asset growth. For that reason, their importance in long-term retirement plans is profound.
Winning in retirement
Our survey found that only 36% of Americans feel confident they will have the income they hope for in their retired years. All the more reason to put excess cash to work. Yet, 20% of investors’ cash is slated for either long-term savings or an investment opportunity, remaining dormant.
Truth be told, the decision to favor cash instead of more productive investments is driven by a fear of losing money today. But it ignores what should be a bigger fear: not having enough money down the road, in retirement, because of opportunity lost.
Consider that over the past 20 years, a decision to remain consistently invested in the S&P 500 Index of U.S. stocks would have turned a $100,000 investment into $441,141. Missing just the best five days during that 20-year period reduces the ending value to $292,650. If you missed the best 25 days, your $100,000 only grew to $110,920. (Sources: BlackRock and Bloomberg. Represents a hypothetical investment of $100,000 in the S&P 500 Index from 1997 to 2016. Past performance is no guarantee of future results. It is not possible to invest directly in an index.)
Even the best money managers have no way to predict when stock prices will fall. But a good investment plan assumes the market will fall in value at times. We just need to prepare for it, and not be scared off by it.
Ultimately, cash is a bet—one that can come with its own cost over time.