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Why Cash Might Drag Down Your Returns

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Consider eight hypothetical portfolios. The first is a simple blend of 60 percent U.S. stocks and 40 percent U.S. bonds. Each successive portfolio lowers the allocation to stocks and bonds by 5 percent and raises the allocation to cash by 10 percent. In addition, let’s assume hypothetical expected returns for U.S. equities, Treasuries and cash of 4.4 percent, 1.6 percent and 1.2 percent respectively, using BlackRock Client Solutions’ five-year return assumptions for various assets.

As the accompanying chart illustrates, as the percentage allocated to cash rises, hypothetical expected portfolio returns fall. When you go from 0 percent cash to 70 percent cash, the expected annual portfolio return falls by over a third, from 3.28 percent to barely 2 percent.

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While none of these portfolios is likely to produce particularly inspiring returns—a function of already elevated valuations for both U.S. stocks and bond—the difference between the two extremes is still important. Assuming an initial investment of $100,000, over a 40-year horizon, that 1.2 percent difference in returns translates into an over $140,000 difference ($363,000 for the portfolio with no cash vs. $222,000 for the portfolio with the most cash).

For many retirees, this kind of gap represents the difference between a comfortable retirement and a serious financial problem.

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Market Realist – It is advisable that investors allocate a small portion of their portfolio to cash to take advantage of the flexibility the asset offers. However, it is not advisable to carry a bloated cash position since cash might cause a drag on your returns. The volatility of returns for equities reduces over longer time horizons. The chart above shows the highest, lowest, and average annual return of the S&P 500 over various holding periods from 1926–2014. The longer the holding period, the lower the volatility (VXX) of returns. Thus, it makes sense to invest in equities (IVV), which give a better rate of return than cash.

Investors should ensure that they maintain well-diversified portfolios with limited exposure to cash. In today’s markets, US equities may not offer much value. Investors can look to Europe (EZU) (VGK) and Japan (DXJ) (EWJ) for opportunities. Both areas are currently experiencing tailwinds due to the easy monetary policies prevailing in the region.

Read our series on Why you should overcome these 3 bad investing behaviors to learn more about how to overcome investor biases.

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