Cash serves a valuable role in many investors' portfolios. It can pay the bills and fund short-term goals—a key reason it's important to keep enough cash around to meet your immediate needs.
"Don't take investment risk with money you need soon," says Rob Williams, CFP®, CPWA®, managing director of financial planning, retirement income, and wealth management at the Schwab Center for Financial Research. "But keep in mind, cash and cash investments—beyond money you've set aside for spending right away—can be a part of your portfolio as well." Cash, both for savings and expense management and for investing, can help you play defense during market downturns by reducing the impact of market volatility on your returns.
But cash isn't always king, depending on why you hold it. Sometimes our emotions enter the picture and hold undue sway over our investing decisions. Loss aversion—in which the pain of loss is felt more strongly than the pleasure of an equivalent gain—is a real phenomenon and can manifest itself in a number of ways.
For some, it might mean cashing out of investments to avoid losses when the going appears to be getting tough. Others could be avoiding (or not allocating enough) to stocks and other assets that could potentially earn more over time. The result can be a cash-heavy portfolio, which can have a downside. The key is the right balance, for your time horizon and needs.
In this article, we look at three reasons you should consider putting your cash to work.
1. Cash generally loses purchasing power when you factor in inflation
The value of every dollar you hold fluctuates as the broad level of prices (i.e., inflation) rises and falls. Inflation tends to increase over time, which means the dollar you held a year or two or three years ago won't buy as much today.
That loss in purchasing power can add up meaningfully over time. By not investing in stocks or higher-yielding bonds, your money doesn't have the potential opportunity to earn interest or grow. Consider what happens when inflation averages out at 3%.
Inflation can severely erode purchasing power over time
Source: Schwab Center for Financial Research
The "nominal" amount is the stated value. The "real" amount is the value adjusted for the effects of inflation. Inflation is represented by the change in the Consumer Price Index for AII Urban Consumers (CPI-U). From 2002 to 2021, inflation averaged 2.3%. But during some periods in the past, the average was much higher: It averaged 6.2% from 1970–1989. The example is hypothetical and provided for illustrative purposes only.
A person who has $100,000 sees the real purchasing power of that money shrink to $74,400 after 10 years and all the way down to $55,368 after 20 years. In this case, a portfolio made up entirely of cash still loses value—and lots of it—declining 26% by year 10 and by 45% by year 20.
Inflation has been running even higher in recent months. In March 2022, for instance, the consumer price index recorded an annual gain of 8.5%. If that level of inflation persisted, the loss of purchasing power would be far greater than calculated above.
2. Low interest rates can undercut your earning potential
You can allocate your cash in short-term investments to try to keep up with the pace of inflation, but your earning potential is heavily influenced by the current level of interest rates. Historically low rates continue to suppress returns on interest-bearing savings accounts, certificates of deposit (CDs), and money market accounts—all popular vehicles for investing short-term assets. Even with the Federal Reserve enacting the second of what economists currently expect to be a series rate hikes, short-term rates may remain below their long-term averages for several more months.
That means you likely shouldn't wait for rates to rise if you want to stay ahead of inflation, but rather, you should maximize what you can afford to invest in assets with a potential for higher returns over time, such as stocks and bonds. Consider the hypothetical example of two people—Alexis and Diego—who both inherited $200,000 in 2001. To illustrate the point, let's factor out inflation and assume that neither withdraw any of their inheritance.
Investing can have greater potential growth compared to saving
Source: Schwab Center for Financial Research
The moderate model portfolio (allocated 35% large-cap stocks, 35% fixed income, 15% international stocks, 10% small-cap stocks, and 5% cash investments) may not be suitable for all investors. Returns assume reinvestment of dividends and interest. Fees and expenses would lower returns. This chart represents a hypothetical investment and is for illustrative purposes only. The actual rate of return will fluctuate with market conditions. Past performance is no guarantee of future results.
While historical returns are no guarantee of future results, the example highlights the significant gap in returns from being too conservative over long investing periods.
3. Overallocation to cash can limit your opportunities for growth
Moving to a higher cash allocation is a lever that investors often pull when they believe they need protection against significant losses or liquidity to fund an upcoming expense (e.g., a college education or home purchase), but some go too far in liquidating their higher-yielding alternatives—particularly during market volatility. Schwab's most conservative model portfolio allocates 30% to cash investments, with the balance split between 50% fixed income assets and 20% in equities.
If you're considering ever increasing your cash allocation beyond this threshold, it's wise to keep two things in mind:
- It's difficult to time the market consistently and successfully. Research conducted by Schwab shows that the cost of waiting for the perfect moment to invest typically exceeds the benefit of even perfect timing.
- Cash has historically underperformed other asset classes. The chart below shows that these differences can be significant over time, especially relative to returns for small- and large-cap stocks, international stocks, and bonds.
Portfolio value by investment type compared to inflation
Source: Morningstar, Inc. Based on the copyrighted works of Ibbotson. All rights reserved. Used with permission.
The chart illustrates the growth in value of $200,000 invested in various financial instruments on 1/1/2001. Results assume reinvestment of dividends, capital gains, and coupons and no taxes or transaction costs. Generally small-cap stocks are in the bottom 50% of publicly traded companies based on market capitalization. These stocks are subject to greater volatility. The indices representing each asset class are S&P 500® Index (large-cap stocks); CRSP6-8 Index (small-cap stocks) through 1978, Russell 2000 thereafter; Ibbotson Intermediate U.S. Government Bond Index (bonds); and Ibbotson U.S. 30-day Treasury bills (cash investments). For illustrative purposes only. Indices are unmanaged, do not incur fees or expenses, and cannot be invested indirectly. For additional information, please see Schwab.com/IndexDefinitions. Inflation is represented by the change in the Consumer Price Index for AII Urban Consumers (CPI-U). Past performance is no guarantee of future results.
"Timing the market is technically and, more often than not, emotionally difficult," Rob notes. "But if you have money and savings that you don't need soon, staying invested in stocks and other investments has more potential to earn a higher return over time."
Also, keep in mind that you should revisit your portfolio and evaluate your plan regularly (annually is a good place to start). Your plans and risk tolerance might change due to any number of extenuating circumstances, and portfolios need to be rebalanced as allocations to any asset class—stocks, bonds, and cash among them—can get out of sync with your plan and goals over time.
Bottom line: Cash isn't always the safe course
There are plenty of good reasons to keep some of your hard-earned savings in cash and cash investments. But make sure that based on your goals, you're not holding too much—especially because you're wary of volatility in investments in the short-term. Holding outsized cash positions can reduce long-term earnings potential.
This is particularly relevant in the case of younger investors, who have plenty of time to make up for market downturns before they need to tap their savings. And it's also true of those approaching retirement, who might be able to pad their retirement savings by reducing their cash balances.
"When I ask clients why they aren't investing their money in assets with higher earning potential," Rob explains, "the answers I hear more often—especially after a number of years of strong market performance—are a fear to commit to stocks or higher-yielding bonds that are perceived as too expensive, the threat that a market correction is underway or imminent, and the assumption that rising interest rates are causing or will cause the value of bonds to fall."
The best defense against making emotional investment decisions is to invest in a disciplined way. Based on when you need the money, save and invest each month in a diversified basket of investments with the potential to grow with the U.S. and global economy over time. How you split your assets between stocks, bonds, cash, and other asset classes can change as conditions or the timing of your needs warrant.
But the key is to maintain at least some exposure to all of them, keeping in mind your goals and time horizon. Holding too much cash might seem like the safe course at times, but you might find it costs you more in the long run.