13 Feb 2014 Should You Hold More or Less Cash?
As financial advisors we are often asked, “how much cash should we set aside?” while others wonder, “why hold it at all, given such low returns relative to equities and fixed assets?” A proper answer to the second question requires a discussion of Modern Portfolio Theory – an involved topic for another day. Today, we look at the question more fundamentally, in human terms. Cash means different things to different people.
While there is much debate on the subject of how much cash to hold, we believe the answer depends largely upon the person and how they expect to use their cash savings. For purchases or payments coming in the next year or two, it is probably better to leave funds in bank CDs or savings accounts. If on the other hand, cash savings are intended to cover unforeseen emergencies, or large purchases well into the future (say 4-5 years from now) there may be a better strategy. I say ‘may be,’ because cash behavior depends upon the person and logic does not come close to explaining how most people handle their cash.
In my 32 years advising clients about investing their money I have watched people accumulate large pools of savings, or emergency funds that languish on the sidelines for decades earning paltry returns. In other cases I’ve seen folks get along quite well without reserve accounts beyond their investment portfolios. What is apparent in both cases is a high degree of correlation between savings and past experience investing in the capital markets.
The investment industry, especially banks, is largely to blame for unusually large balances of savings. When people have been burned badly in the stock market they tend to cling more fervently to savings as a last resort. And to make matters worse, it was the banks themselves, back in the 80s, turned loose on their unsuspecting CD clients by Congress and Federal regulators to sell them mutual funds and variable annuities with little or no warning of the potential risks nor overall needs analysis or portfolio strategy.
On the other hand, people with good investment experiences in the capital markets are generally more likely to have smaller or no savings accounts, choosing instead to ‘save’ for future spending and unforeseen emergencies in their primary investment portfolios. They trust their investment advisers and the allocations of stocks and bonds in which they invest to meet their needs as they arise. Indeed their experience generally warrants that trust.
A study in today’s Wall Street Journal’s Money Beat Tells of a group of financial-planning experts from several different colleges who studied how much investors might be giving up in terms of potential long-term returns by holding stockpiles of cash. The results, first published in the Journal of Financial Planning, found that such so-called “opportunity costs” could range from .76% to over 1% during 40-year accumulation periods. Doesn’t sound like much? The difference represents close to 50% more money at the end of 40 years. With Social Security likely waning in importance for retirees in the next 20 to 40 years, 1% can make a huge difference.
“Instead of accumulating cash in a separate account, investors can simply sell securities from their investment portfolios, which hold greater potential to take advantage of market appreciation over time,” says the study’s co-author Duncan Williams, professor of financial planning at William Paterson University in Wayne, N.J.
But we understand that the question of savings is much more an emotional issue than it is a logical or planning one. For this reason there can be no effective rules of thumb. One strategy does not work for all. We are each unique in our needs and concerns. A good financial advisor understands that no studies or cajoling will change what is deeply ingrained in a person’s emotions. He or she works with each individual to tailor a plan that is best suited to meet or exceed his client’s future needs, while respecting and minimizing any sacrifices to current lifestyle, whether that translates to holding more cash for emotional security or less to minimize “opportunity cost.”