Why Sitting in Cash is Bad
“I have a bunch of money sitting in a checking account, what’s one thing I can do right now to increase my returns while I figure out a longer term investment strategy?” -Matt, Washington
The Economist just published an article, “How the young should invest”. The author describes five “traps” that young people fall into. Here’s the first:
“The first trap—holding too much cash—is an old one. Yet youngsters are particularly vulnerable. Analysis of 7m retail accounts by Vanguard, an asset-management giant, at the end of 2022 found that younger generations allocate more to cash than older ones. The average portfolio for Generation Z (born after 1996) was 29% cash, compared with baby-boomers’ 19%.”
I help young couples get started on the right foot with their finances, so I’ve seen a bunch of millennial and gen z portfolios. They pretty much all have a higher allocation to cash than you’d expect. The author continues:
“Whatever its motivation, young investors’ preference for cash leaves them exposed to inflation and the opportunity cost of missing out on returns elsewhere. The months following Vanguard’s survey at the end of 2022 provide a case in point. Share prices surged, making gains that those who had sold up would have missed. More broadly, the long-run real return on Treasury bills (short-term government debt yielding similar rates to cash) since 1900 has been only 0.4% per year. In spite of central banks’ rate rises, for cash held on modern investment platforms the typical return is even lower than that on bills. Cash will struggle to maintain investors’ purchasing power, let alone increase it.”
The simplest reason to invest instead of keeping all of your money in cash is because of inflation. The inflation rate is how much the price of goods and services change over time, usually measured over a year or month over month. The US Federal Reserve has a target of 2% annual inflation. It’s been quite a bit higher than that over the past two years.
What does inflation do to you? It reduces your purchasing power. It’s why a Chipotle burrito was $5 in 2007 and costs $10 now (without guac). It’s why back in your grandaddy’s day, a Hershey’s bar cost 10 cents and now it’s $1.50.
Cash simply doesn’t keep up with inflation over time.
Let’s say Matt has $100,000 in cash in his checking account in 2023. What will the purchasing power of this lump sum be in 2043 with a 2% inflation rate? Well, growing $100k at 2% a year gets you to $148,595. That means you need $148,595 in 2043 to buy the same amount of goods as $100,000 would get you today.
If you change the inflation rate to 3.5% (closer to the 100-year historical US average), the number jumps up to $198,979. In just 20 years, you need TWICE as much money to buy the same thing. Expect one chipotle burrito to cost you between $15-$20 in the 2040’s. Yikes!
Investing over the long-term gives you a chance to grow your money above the long-term inflation rate. Investing gives you a chance to maintain your purchasing power, and likely increase it.
I also want to address the phrasing of Matt’s question. What should I do with my cash while I figure out a long-term investment strategy?
Imagine you are playing a game of Settlers of Catan. You place your initial settlements on solid number combinations and your roads aren’t being blocked by another player.
The game begins and your numbers keep getting rolled. You are accumulating resource cards and your hand is overflowing with potential.
But then, you just….never build anything. You don’t build any roads, settlements, or development cards. You just keep accumulating resource cards. Eventually, someone rolls a seven and as per the rules, you have to discard half your hand.
This doesn’t change anything, as you continue to hoard resources cards in your hand without building anything. Every seven cuts your hand in half again and again. Your opponents keep looking at you oddly.
You eventually lose the game. They ask you why you didn’t build anything and you reply, “I was waiting to figure out a long-term strategy”.
This Catan scenario is not exactly what Matt’s scenario is, but it kind of is what Matt’s scenario is.
Keeping your money in cash in your checking account is like keeping all of your resource cards in your hand and never building anything.
What does spending your resources in Catan do?
Build roads and you can expand your empire.
Build cities and collect more resources when your numbers are rolled.
Build a settlement on a harbor and trade resources at a more favorable rate.
Deploying your resources accelerates your power and standing in the game. The more you build the better your chances of winning are.
Investing in the real world is the same way. You can spend your resources (cash) and buy slices of businesses that will earn you more resources (appreciation and dividends) in the future. You can lend your resources to the government or companies and earn resources (interest) for doing so.
Often times young people keep more cash than they need because it’s tough to know how or why to start investing if no one is walking you through it.
This inspired me to create my guide, Where To Start With Money? It’s my take on how to think about organizing your financial system so that it works for you in the long run.
If you understand your own financial system and how it works, you can plan where every future dollar of income goes in advance. You don’t have to wait around in cash thinking for a long-term strategy, because you already have one.
The truth is, the inflationary world we live in penalizes you for not deploying your resources. You need to play the cards in your hand.
So what’s one thing Matt can do right now to increase his returns while he figures out a long-term investment strategy? Figure out his long-term investment strategy.