Too much cash: There is such a thing

That’s the way a lot of people seem to think, but turns out it’s wrong. Holding a lot of cash in your portfolio is actually very risky. That’s because cash is pretty much the only investment out there that has absolutely no potential to earn a return in excess of inflation. Yet today, many Canadians are taking just that risk.

The 2014 BlackRock Investor Pulse Survey, conducted by the giant global asset manager in August, showed that almost two-thirds of Canadians’ financial assets are parked in low-yielding, short-term instruments. There’s no definitive answer as to why, but the survey points to safety and caution as the prime reasons.

The survey also found that Canadians think the ideal level for cash is much lower than the current experience. Most cite a range between 20% and 31% of financial assets, depending on age and size of portfolio. The significant gap between reality and target begs the question: how did we get to such an extreme situation?

Clearly, some investors bailed out of the stock market. They couldn’t take the pain. And it has been my observation over many cycles that one of the hardest things to do in investing is to get back in after getting out.

Many cash-rich investors didn’t sell when the market crashed (at least not completely), but also didn’t buy into the stock market in subsequent years. New money went into GICs and high-interest savings accounts, and as a result their asset mix gradually shifted away from their long-term target. I’ve found that many investors are surprised by the degree to which this creep has impacted their mix. The short-term investments often add up to a higher percentage of their portfolio than they thought, or intended.

No matter how we got to this place, I do know there’s an underlying assumption that cash connotes safety. There’s no chance of losing the capital. But holding too much cash is dangerous because if you don’t achieve a return in excess of inflation, the purchasing power of your portfolio will decrease. Consider that after 10 years of 2% inflation, you’ll need $121,000 to buy the same basket of goods that $100,000 does today. In other words, the cash in your portfolio is actively losing its value every year.

READ: Investor’s Guide 2015 »

If your money isn’t needed for five years or more, your portfolio should consist primarily of long-term assets that will generate a positive real or after-inflation returns—a mix of bonds, stocks and real estate. Cash and short-term notes may be part of the mix for tactical reasons, but they should only make up 5% to 10% of your holdings.

I say this because both bonds and stocks beat cash over longer time periods. Go back more than a century and there’s only two instances when there was a negative 10-year return for the S&P 500: the decades ending in the late 1930s and in 2008/2009 when it had small negative returns. A balanced portfolio of bonds and stocks has never had a negative return over a 10-year period.

Unfortunately, no one knows when returns will come, so timing the market is impossible. Even professional managers have a poor record in this regard. When combining the timing challenge and the higher historical returns for bonds and stocks, it’s evident that cash-heavy investors are swimming against the current.

The most recent decade demonstrates the point—it had a bit of everything including big ups and downs, dramatic swings in investor sentiment, and a major financial crisis in the middle. A balanced portfolio of exchange-traded funds (ETFs) made up of 40% bonds and 60% stocks had an annualized return of slightly more than 6% (to Sept. 30, 2014). An initial investment 10 years ago of $100,000 grew to $184,000.

In contrast, a strategy of buying the highest yielding five-year GICs would have produced roughly a 3% annualized return and grown the invested capital to only $134,000. That $50,000 gap is a pretty steep price to pay for predictability.

If you don’t need money from your portfolio until well into the future, then a weak stock market in the near term is not your biggest risk. Indeed, volatility can be a good thing for investors who are contributing new money to their portfolios. Down markets give them an opportunity to buy more shares in a company, or units in a mutual fund, with the same amount of money. Who doesn’t want to buy something on sale?

If you’re saving money for a short-term goal, the default position is money in a bank account or GIC. A saver needs certainty, not volatility.

If you’re investing your default position shouldn’t be a savings account or other banking product. It should be your long-term asset mix. Strategies to enhance returns should revolve around that mix. And consistent with a long time horizon, it’s expected that your portfolio will experience many zigs and zags along the way.

If you find you’re too cash-heavy, then you need a plan for getting back to your target. Your plan may call for you to buy stocks in stages over the next 12 to 24 months. Making the plan automatic, with set dates, will take the emotion out of the process. There’s nothing exact about asset allocation, but when you let cash take over your portfolio, in effect, you’ve made an investing choice—and it’s not one that will lead to long-term success.

Tom Bradley is president of Steadyhand Investment Funds. He writes regularly about investment issues on his blog at steadyhand.com/tom.