Charting The Most Dangerous, Wealth-Destroying Investment

by: Lou Basenese

The Fed speaks. Stocks tank. And now I'm here with a friendly public service announcement: Don't give in to your flight instinct. Running for cover in cash right now promises to be the worst possible move.

I know, I know. Cash is supposed to be the ultimate safe haven. A riskless investment, if you will. In truth, cash is the proverbial "Death Star" (more on that later). If cash is so great, why in the world would Warren Buffett have said, "The one thing I will tell you is the worst investment you can have is cash"?

If you know better than one of the world's richest people, you go on with your bad self. As for the rest of us? Well, we're going to tackle this head-scratcher of a market and the dangerous temptation of cash.

Smells Like an Overreaction

On Friday, I tried to calm your nerves about the latest market sell-off by sharing Japan's history with "tapering." (Reminder: It's not the end of the world.) Based on your emails, though, I can confidently say that I failed. So maybe hearing it from someone else will do the trick? Let's hope so.

Jeff Kleintop, chief market strategist at LPL Financial, said, "This feels like an overreaction. The Fed didn't tell us anything we didn't already know." Agreed. Recall that Fed Chairman Ben Bernanke warned about the inevitability of the end to quantitative easing back in May.

Meanwhile, Philip Orlando, chief equity strategist at Federated Investors, which manages over $375 billion in assets, said, "It's a knee-jerk downward reaction, because everyone is afraid that if you're taking the punch bowl away, that must be bad for markets." How true. It's as if in two days' time we forgot that stocks could ride a bike (rally) without training wheels (the Fed).

Even with the experts on my side, I'm sure some of you still can't help cueing up Le Chic's "Freak Out" in response to the latest stock market volatility. And that's precisely why we need to have the dreaded talk. About cash, that is.

Forget Crack -- Cash Kills

When investors worry or panic, they scurry into cash like a toddler into their parent's bedroom during a thunderstorm. But as Buffett said, it doesn't do a portfolio any good. Not if you hold on to it for more than a few months. And here's the irrefutable proof:

Every year since 1926, cash averaged negative returns when we factor in inflation and taxes. That bears repeating. Cash averages negative real returns on an annual basis. (How's that for safety and preservation of capital?) That means the more cash you hold, the poorer you can expect to get over time, which essentially makes it the "Death Star" of the investment world.

The dangers of cash are particularly troublesome if you're in (or close to) retirement. Why? Because at that stage of the game, many investors shift a meaningful amount of their portfolio into cash. Yet doing so actually increases the odds of outliving their assets, thanks to longer average lifespans.

Consider a $500,000 portfolio, with 5% inflation-adjusted withdrawals each year:

As you can see, an investor who is 100% in cash (or even 100% in bonds) runs out of money about 10 years before an investor who is 100% in stocks or in a diversified portfolio (50% stocks, 30% bonds, 20% cash). Clearly, Buffett knew what he was talking about when he said cash is the worst investment.

Remember, We Still Stink at Investing

Maybe you think you can overcome the pitfalls of cash by only holding on to it for a few months and then buying back into stocks. In other words, maybe you fancy yourself a savvy market timer. The numbers suggest otherwise, though.

As I shared in March, the average investor stinks at investing. (Sorry to be blunt. But it's true.) Research from BlackRock shows that they underperformed every major asset class for the last 20 years.

How could that be? Blame it on making knee-jerk reactions during volatile times. Or, as BlackRock says, "Amid difficult financial times, emotional instincts often drive investors to take actions that make no rational sense but make perfect emotional sense."

I'd say bailing on stocks and piling into cash qualifies as a purely emotional response to the latest volatility, wouldn't you? Bottom line: If cash had a tagline, it'd be the opposite of Nike's -- just don't do it!

Although it might seem like a safe investment, particularly when stocks start selling off, it's anything but. Of course, that raises the natural question: If not cash, then what? You'll have to wait until tomorrow to find out. That's when I plan to share five smarter (and safer) alternatives to running for cover in cash.