Is Cash Actually Risky?
Cash is king, as they say. There are multiple roles for cash in a financial plan. Cash flow is obviously important. A cash reserve, or emergency fund, is also important to take care of those “life happens” moments. However, cash in an investment plan is not as well understood. Many people like a lot of cash, especially as they near retirement, because they think it means their money is safe, or doesn’t carry much risk.
In some ways this is likely true, especially if it is FDIC insured. But this mindset confuses purchasing power and currency. $1 is always $1. That is currency. But in real life, $1 will buy less than it does today over time because of inflation. Great examples of this are the annual increases in Medicare premiums and Social Security benefits. In 2020, Medicare will go up about 7%, while Social Security benefits will only increase 1.2%.
That is the power of inflation. Inflation is one of the “deep risks” that William Bernstein talks about in his book Deep Risk: How History Informs Portfolio Design. This is why one our investment beliefs is “The purpose of investing is to maintain and grow purchasing power over long periods of time.” Understanding this concept reveals two paths forward.
In the short term, inflation can’t do too much damage. It certainly still matters, but it can’t devastate you. Taking the Medicare/Social Security example, that increase isn’t going to hurt you too bad in one year. The far greater risk over this short time-frame is having all your money in the stock market and and having to sell when it’s down 35% or more. This is called the risk of volatility.
For this reason, cash is usually the way to go in the short term. If you plan to use money in the next year or so, cash is the right choice.
A lot of people think of asset allocation as starting with 100% stocks and adding more bonds as you approach retirement. This manifests itself with a focus on “risk tolerance”. This is important because the worst thing you can do is begin with a portfolio that is too aggressive and you end up panicking and selling at the absolute worst time.
While risk tolerance is important, I prefer starting with cash, much like Jonathan Clements describes in this article. The money you need to spend in the next 5-10 years should not be in stocks due to this risk of volatility. The rest can logically be put into stocks and you repeat the process each year through strategic rebalancing.
So, if cash is the solution to volatility risk and the friend of a short-term investor (or for the short term spending of a long-term investor), it is reasonable to say the inverse: Cash can be risky for the long-term investor and is not the solution to inflation risk. It is also reasonable to say that the risk of a temporary stock downturn, even a severe one, is not as risky as inflation to the multi-decade investor.
Let’s revisit the Medicare/Social Security example. If small increases continue year after year, eventually it will have a significant impact. The metaphor of the frog placed in a pot of room-temperature water comes to mind. Once the stove is on, the change in temperature is so gradual that the frog never senses any danger until it is too late. This is how inflation works and is one of the primary reasons pre-retirees and recent-retirees shouldn’t abandon stocks altogether.
To recap, the further away you are from needing the money (time horizon) and the longer you need the money to last, the less cash you should hold.