Many investors are hoarding cash. Some are drawn towards the safety of cash, and others lack confidence in the alternatives. Investors with too much cash are often timing the market to avoid potential losses.
But, experience proves that investors who hold too much cash will achieve poor long-term results and incur large opportunity costs. So to combat cash hoarding bias, this post describes the main reasons why investors hold too much cash, how it affects returns, and how to overcome it.
Some cash is ok – depending on your goals
Its prudent for most investors to hold some cash. Having enough cash available to pay for day-to-day living expenses is prudent. For many, this means having enough cash in a bank account that will satisfy a year’s worth of living expenses.
Some investors also save extra cash for emergencies. Its common for many investors to keep an “emergency fund” in case of medical emergencies, unexpected home & car repairs, and to fund other expenses that may suddenly arise (like supporting a family member).
After having enough cash to cover day-to-day living expenses and having a financial emergency plan in place, any extra cash will simply be a drag on investment returns. Here are three reasons why:
- Inflation
- Taxes
- Better Investments Exist
Inflation is bad
Inflation is the general increase in the price of goods and services over time and the relative decrease in the value of money. It erodes the purchasing power of money. Therefore, holding too much money exposes investors to inflation.
When an investor holds cash on deposit, they are essentially holding onto a fixed amount of money. When the rate of inflation exceeds the interest earned on cash (as it naturally does), the purchasing power of that cash will decrease over time.
What about taxes?
Interest income is taxed at the highest marginal rate. Other types of income, such as dividends from stocks and capital gains are taxed at much lower rates.
So, the high tax rates for interest earned from cash deposits are another penalty for holding cash. In many US states and Canadian provinces (such as New York, California, and Ontario) the combined state/federal tax rate is over 50% for interest income.
Cash is a drag
Most active managers under-perform their passive benchmarks. One reason is human emotion (investor psychology), another reason is fees, and a third often overlooked reason is that most active managers hold a portion of their portfolio in cash while index funds do not. Since the stock market outperforms cash over the long-term, holding cash is a drag on returns.
Investors holding cash will under-perform passive benchmarks over the long-term. This is true of all potential benchmarks including stocks, bonds, and real estate.
Overcoming cash-hoarding bias
There are two main reasons why investors hold too much cash:
- Market-Timing
- Fear
Market Timing
Many investors mistakenly believe they can “time the market”. Evidence proves the opposite. The belief in market timing is the result of overconfidence bias.
Worse yet, investors holding too much cash become psychologically anchored to their decision. Some investors move to cash in anticipation of a market crash. But when market rises instead, its difficult for investors to change their mind. Therefore, many investors who tried to time the market end up holding too much cash for far longer than they initially anticipated.
Fear
Many investors hold too much cash because they are afraid of making bad investments. They perceive cash as being a safe investment by contrast. This is due to loss aversion bias.
Investments such as stocks, bonds, and real estate can seem scary at times. The day-to-day gyrations of the stock market can also make some investors feel like they’re on an emotional roller coaster. But, over the long-run, investing in stocks, bonds, and real estate provide far superior returns compared to the interest earned on cash.
Here are some ways that cash hoarders can overcome market-timing and fear:
- Don’t let emotions get in the way
- Have a plan, and stick to it
- Dollar cost average
- Diversify
Emotional Bias
Investing can be emotionally taxing. The financial headlines and the day-to-day movements of markets can make us all feel nervous, anxious, and fearful sometimes. But good investors must also be brave.
While being brave doesn’t mean all investors should take big risks. Successful investors will keep a long-run mindset by focusing on making high quality investments that align with their values & goals. They don’t allow the day to day headlines to take them off-course.
To overcome our emotional biases, we should first acknowledge them. We’re all exposed to loss aversion bias, overconfidence bias, and anchoring bias. We all feel fearful and anxious sometimes. And once we acknowledge this, we can begin to learn how our emotions impact our investment decisions so that we can rise above them.
Planning
Investors who make plans are more likely to achieve their goals. This means investors who write out their values & goals and create simple Investment Policy Statements find it much easier to avoid investing biases.
Dollar Cost Averaging
Dollar cost averaging is an investment strategy in which an investor regularly invests a fixed amount of money into an investment over time, regardless of the market conditions. This means that regardless of whether the market is up or down, the investor keeps investing.
Dollar cost averaging can help investors avoid holding too much cash because it encourages us to invest our money on a regular basis, rather than trying to time the market or waiting for the “perfect” moment to invest. Also, investors who are holding too much cash out of fear or the belief that the market may fall can use a dollar cost averaging strategy to ease their way into a diversified portfolio over time.
Diversification
A final way to combat the fear and bias that keeps us from investing our cash is to create a diversified portfolio. A diversified portfolio is one that is balanced between different investments within various asset classes such as stocks, bonds, and real estate. A diversified portfolio is much less exposed to risk compared to one that is concentrated in any one investment or sector.
Over time, a diversified portfolio will outperform cash by a wide margin. And, a diversified portfolio that reflects our values & goals will provide us with much greater financial peace of mind.
Holding less cash doesn’t mean taking wild risks
Some investors are holding too much cash because they correctly see the stock market and real estate as investments that don’t align with their goals. This may be true sometimes. Some investors have a low risk tolerance or a short-term time horizon.
Low risk investors should still avoid cash.
Instead of holding cash on deposit, low risk investors might consider adding other fixed income investments to their portfolio such as bonds, mortgage funds, and other income focused investments such as Real Estate Investment Trusts (“REITs”).
Low risk investors holding too much cash might also consider lengthening the duration of their holdings to include bonds & GICs/CDs with longer maturities and maturities that match their investment goals. Low risk investors should also consider annuities and other guaranteed investments that favour preservation of capital while still providing returns greater than cash on deposit.
Don’t let the currently high rates fool you
Some cash hoarders may believe the high rates of interest they currently receive on their cash deposits are fair compensation. But, thinking so is a mistake. Banks will only offer interest rates to depositors that are low enough for them to earn a better return elsewhere.
Banks are not in the business of giving out free money to depositors.
So, think like a bank, consider a wider selection of investments instead of just cash.
Conclusion
While it may be prudent for investors to hold some cash for day-to-day living expenses and emergencies, holding too much cash can have significant long-term costs. Investors who hoard cash risk losing out on potential investment returns due to inflation, taxes, and focusing on more suitable investments. By overcoming emotional biases, having a plan, using dollar cost averaging, diversifying investments, and considering other fixed income and guaranteed investments, investors can avoid hoarding cash and achieve better investment results over time. It’s time to stop letting cash hoarding bias impact investment returns and start taking the steps necessary to invest with confidence to reach long-term financial goals.
