Six years into one of the better bull markets of the modern era, investors are still holding onto a lot of cash. According to a survey last year by State Street’s Center for Applied Research, globally retail investors are holding 40% of their assets in cash. Is this a good idea? The answer may be no.
Negative returns. Cash is one of the three major asset classes and it serves several legitimate purposes in a portfolio: it dampens volatility and provides liquidity. The cost is that cash typically produces much lower returns than stocks or bonds. Once you adjust for both inflation and taxes, average returns have been negative (See chart below).
Given that U.S. short-term interest rates are stuck at zero, and are likely to remain unusually low for some time even if the Federal Reserve starts to raise rates later this year, return for cash this year is almost certain to be negative. The only potential exception would be if the U.S. enters a deflationary environment.
Help cushion volatility with bonds. It’s true that the volatility of cash is low, but there are other ways to potentially bring down volatility in a portfolio: adding bonds is one option.
Consider this simple example with a three-instrument portfolio comprised of a S&P 500 ETF, a long-term bond ETF and a cash-proxy ETF.1 Based on daily returns since 2010, the annualized volatility on the cash proxy (a short-term bond ETF) is effectively zero, compared to 16% and 15% for the stock and bond ETFs. A quick glance at these numbers seems to suggest that the best way to dampen portfolio volatility is to hold a lot of cash, but this conclusion ignores the important diversification benefits of bonds.
For the past five years or more, bonds have had a strongly negative correlation with stocks; in this environment, adding bonds to a stock-heavy portfolio now is highly diversifying. Unless you have an unusually low risk tolerance, an outsized cash allocation is rarely optimal.