The market and economic mayhem experienced since 2008 has driven many investors to park their assets in cash. FDIC data shows bank deposits hit $10 trillion at the end of 2011, up from $6 trillion in 2006.
"This is understandable given the difficult market environment of the last few years," says BlackRock President Rob Kapito, "but with cash providing negative real returns after accounting for inflation and taxes, investors have to realize the very high cost of holding it."
Safety Is Not Free
While putting your hard-earned dollars in a "riskless" asset may seem like a good idea when times are uncertain and volatile, it's a strategy that comes at a cost. Holding too much cash will cause the real (inflation-adjusted) value of your portfolio to diminish over time. Even in the low-inflation environments in much of the developed world, returns on cash have not kept up with consumer price increases.
Sitting in cash also raises the probability that you will not meet your long-term investment goals. Given the wealth of opportunity in other areas of the marketplace today, says Mr. Kapito, "investors are giving up returns that will be difficult to earn back."
The Long-Term Cost of Cash
Holding cash can be particularly problematic for those in or nearing retirement. Many investors shift large portions of their portfolios from higher-risk assets to so-called "safe" assets as they enter retirement. This may make intuitive sense, but retirees still must contend with inflation and taxes as they draw down their nest eggs. With populations living longer, withdrawing funds from a portfolio comprised entirely or largely of cash can make savings shrink faster at a time when it's needed longer.
There are good reasons to hold cash in a diversified portfolio: It can cover emergencies, so you don't have to sell long-term investments; it can smooth out returns and balance the risks of other asset classes; it can be a short-term parking place for savings before you decide on a new investment strategy; or it can fund future investment purchases.
But cash is not a prudent long-term investment strategy. Mr. Kapito recommends investors take a step back, assess their goals and work with their financial professionals to make their money work harder for them.
"Staying stuck in neutral by holding too much cash is not going to help investors achieve their ultimate goals," he says. "We want people to be aware of that risk."
Sources: BlackRock; Morningstar; Tax Foundation. Past performance is no guarantee of future results. Assumes reinvestment of income and no transaction costs. For illustrative purposes only and not indicative of any investment. Federal income tax is calculated using the historic marginal and capital gains tax rates for a single taxpayer earning $110,000 in 2011 dollars every year. This annual income is adjusted using the Consumer Price Index (CPI) in order to obtain the corresponding income level for each year. Income is taxed at the appropriate federal income tax rate as it occurs. Capital gains for stocks are assessed every five years when there is a cumulative gain from the last high and assume a five-year holding period to determine the long-term capital gains rate. Bonds are assumed to be held to maturity. No state income taxes are included. Stocks are represented by the S&P 500 Index. Bonds are represented by the Morningstar/Ibbotson Intermediate-Term Government Bond Index. Cash is represented by the Morningstar/Ibbotson 30-Day US Treasury Bill Index. Inflation is represented by the CPI. It is not possible to invest directly in an index.
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