What cash provides – and what it doesn’t – over time
Cash as an investment portfolio component provides some benefits but also drawbacks. Among the benefits are protection against market volatility, the security of a stable value, and the flexibility to have liquid assets available to invest or spend as opportunities arise. A key drawback is the loss of purchasing power, as cash returns have historically not kept pace with inflation. Cash is not an effective long-term wealth-creation vehicle.
Liquidity, stability, and optionality
Three reasons to keep money on the sidelines in cash are liquidity, stability, and optionality. Maintaining a portion of your portfolio in highly liquid assets (i.e., Treasury bills, money market funds) gives you access to cash for unexpected spending. Stability means the principal of your cash investments is preserved. Optionality leaves you in a position to deploy capital in investments or other spending at a later date, in essence, keeping your options open.
The opportunity cost of staying on the sidelines
Keeping investable money on the sidelines to protect against short-term market volatility can be detrimental in the long run. The opportunity cost of holding cash is the loss of compound interest from stock and bond returns. Because it is difficult to predict when markets generate their largest returns, those trying to “time the market” by holding cash risk missing some of the market’s best days.