Choosing Cash Over Equities: Not the 'Safe Play' It Appears to Be

Includes: DIA, IVV, IWV, QQQ, SPY, VOO
by: Kevin Feldman

Young investors who keep their money in cash may think they’re playing it safe, but the strategy could cost them in the long run.

A recent Bank of America-Merrill Lynch survey found that almost half (47%) of 1 ,000 affluent Americans—defined by Merrill as Americans with investable assets in excess of $250, 000—describe themselves as “conservative investors,” meaning that they favored low to moderate risk investments intended to deliver modest but steady gains. Among young investors aged 18 to 34, that number soared to 59 percent. (As compared to 41% among investors aged 35-64.)

What’s striking about these findings is that they’re basically a reversal of conventional financial wisdom, which holds that younger investors should take on more risk than older ones; since they have more time before retirement, they can afford to be more aggressive in search of greater gains, which are then compounded over decades. Older investors, however, won’t have as many years before retirement to recover from potential large downturns in riskier investments. Younger investors are typically the ones who buy growth-oriented equities, while older folks are typically the investors moving their portfolio into less risky and income-generating investments.

What’s going on? The consensus is that older investors’ attitudes were shaped by the long-running bull market of the mid-1970s through the late 1990s. Younger investors, however, had less time to form positive impressions of the market before being hit by two crises in less than a decade: the bursting of the tech bubble in 2000 and 2001, and the recent market plunge of 2008 and 2009. So while older investors saw a quarter-century of upward movement before a sustained plunge, younger investors saw deep drops bracketing a few years of growth.

Given the economy, younger investors are also likely to have an understandable fear of unemployment, and so want to keep cash on hand—as opposed to investing it in equities that, in their experience, can suffer massive drops in value. It’s the modern equivalent of people who lived through the Depression stuffing cash under their mattress.

I can understand why younger investors lack confidence in equities, but I can’t endorse the strategy. Playing it safe in reaction to past crises is investing by looking in the rear view mirror, and ironically, it really isn’t playing it safe at all—more like the opposite.

For two reasons. One, investors who allocate too much of their retirement portfolio to cash or fixed income will likely lose out on the higher gains that equities have historically generated over long-term periods. They’ll also lose out on the compounded value of those gains between now and their future retirement years.

And two, they may lose money by not keeping up with inflation, as is entirely possible when keeping your money in cash or short-term bonds, particularly at current interest rates. Most financial advisors would tell you that only if you strongly believe we’re headed for deflation, or if you have a near-term plan for a major purchase such as a home, does it make sense for a younger investor to hold 1/3 of his or her portfolio in cash.

This is the kind of longer conversation that investors should really have with their financial advisors, of course. But broadly speaking, for younger investors the old advice is still sensible: Start saving as early as you can and don’t stop. Diversify, diversify, diversify. Keep costs low and be tax savvy in where you place your investments.

Keeping your money under the mattress—figuratively or literally—is not the road to a comfortable retirement.

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