Late in 2008, shortly after the market crash, I provided financial advice to a woman as part of a free financial clinic sponsored by the Financial Planning Association.
We were discussing ways to preserve and grow her investments when she mentioned the approach taken by her 85-year-old aunt. The aunt simply buried her savings in coffee cans in her backyard!
Although I’d be amazed to find anyone else following this practice nowadays, I do in fact meet many people who keep most of their savings in cash, using bank CDs, money-market funds and other minimal-risk investments.
Since 2009, the amount of cash that flowed out of equity mutual funds and was invested primarily in stocks has been unprecedented. That’s not surprising given the pummeling most 401(k) and other retirement accounts have taken, not to mention the subsequent roller-coaster performance of stocks. Remember 2011?
What risk-averse investors may not realize, however, is that after taking inflation into account, there are very few periods of time when cash outperforms stocks.
The accompanying chart (bottom chart, right) compares the growth of $10,000 invested in cash (30-day Treasury bills) to $10,000 invested in stocks (Standard & Poor’s 500 stock index fund) over the five-year period beginning at the market peak in 2007. That time frame represents the second worst period for stock performance since 1932. All amounts are adjusted for inflation. The graph illustrates that both investments performed equally over this period. Note that both would have lost approximately 8 percent in real terms, adjusted for inflation.
Now, examine the same data (top chart, right) over the previous 15-year period. The purchasing power of the equity investment would have grown 40 percent more than that of the cash investment, which declined throughout and beyond the two market downturns. A key reason was that interest rates remained lower than the inflation rate during those periods.
There are two lessons here. The first is that stocks will outperform cash on a real basis over time, especially when inflation is rising. In general, cash cannot keep up with inflation, so if you have not saved enough during your working lifetime to pay for your retirement, leaving your savings in cash will simply not work.
The second is that stocks are not a good place to invest cash that you expect to use within a few years. If you had planned to buy a house in 2009, for example, investing the down payment in stocks during 2008 would have been catastrophic.
Based on that, you should not keep all your money in cash, nor should you invest all of it in stocks. Instead, here’s a simple investment strategy you might consider: Invest funds in stocks for goals that are more than five years away, switch to cash when the time horizon shrinks to less than five years.
Even better, there are many asset classes available for investment in addition to stocks and cash, each with its own risk-reward performance and characteristic response to different economic conditions. No asset class can be guaranteed to work for you over time and all the time, and that includes cash.
Los Altos resident Artie Green is a Certified Financial Planner with Cognizant Wealth Advisors. For more information, call 209-4062.