Cash has its place in any financial plan. However, holding too much cash or cash-like investments like a CD or a Money Market account can be one of the most overlooked risks when it comes to long-term planning.
Inflation Creates Permanent Loss
Traditional wisdom says if you want to preserve your dollars, keep them as cash. Yes, this level of caution can help reduce short-term volatility or loss of capital. Unfortunately, unbeknownst to many investors, cash is not as risk-free as it seems. Holding too much cash long-term can come at a high price.
Inflation is defined by the Federal Reserve as "the increase in the prices of goods and services over time.”[1] For investors, inflation is a silent killer that, if unchecked, can permanently deteriorate their purchasing power. To stress this, see how quickly your money can be cut in half based on different inflation rates.
Build a Diversified Plan
Inflation requires investors to think long-term. Balancing temporary risks with combating inflation is an essential element of building a successful financial plan.
Long-term investors who want to combat rising costs due to inflation should look to build a diversified investment strategy with an appropriate amount of stocks. While the stock market entails short-term volatility, it has never experienced a total and permanent loss. In fact, stocks have done just the opposite.
When Should I Hold Cash?
This is not to say someone ought to avoid holding cash altogether. Strategic cash cushions do have a significant place in a financial plan when considering both short-term and long-term financial decisions (see the barbell approach). There is no one size fits all plan. The amount someone should keep on hand should correspond with their living expenses, instability of income, stage of life, risk tolerance, etc. This amount is typically 3 to 12 months of living expenses. However, the permanent risk associated with holding too much should be evaluated, and if possible, mitigated. This starts with a deliberate and personalized plan concerning how much to hold and where to keep it.
Decisions around cash are just as psychological as they are financial. For this reason, it can be helpful to enlist the help of a trusted partner like Human Investing who has your best interest in mind.
Sources
[1] Federal Reserve (2016). What is inflation and how does the Federal Reserve evaluate changes in the rate of inflation?
[2] Inflation Data source from 1/1/1926-12/31/2021: Ycharts.
[3] U.S. Centers for Medicare & Medicaid Services. “Projected | CMS.”
[4] CFA Institute (2021). Stocks, Bonds, Bills, and Inflation (SSBI®) Data.
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Will Kellar, CFP®
Will is motivated by the opportunity to serve hardworking people and their financial pursuits, through advocacy, problem solving and great advice. He’s a CERTIFIED FINANCIAL PLANNER™ practitioner who loves the feeling of when our team makes a positive tangible impact in someone's life.
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Human Investing Blog
As a seasoned financial expert with a deep understanding of wealth management, I find it imperative to emphasize the often overlooked risks associated with holding excessive amounts of cash in a financial portfolio. The article touches upon a crucial aspect of financial planning, particularly the impact of inflation on the long-term value of cash holdings.
First and foremost, the article accurately highlights the Federal Reserve's definition of inflation as "the increase in the prices of goods and services over time." This is a fundamental concept that every investor should comprehend, as inflation poses a silent threat that can erode the purchasing power of cash over time.
The evidence supporting the argument against an overreliance on cash includes a reference to historical inflation data. By demonstrating how different inflation rates can quickly erode the value of money, the article emphasizes the importance of considering inflation as a significant factor in financial planning.
The solution proposed in the article aligns with investment best practices: building a diversified investment strategy with an appropriate allocation to stocks. It stresses the importance of long-term thinking and balancing temporary risks with combating inflation. The mention that the stock market, despite short-term volatility, has never experienced a total and permanent loss reinforces the idea of stocks as a reliable hedge against inflation.
The article also addresses the question of when to hold cash. It acknowledges that holding cash has its place in a financial plan, particularly for short-term and long-term financial decisions. The recommendation of maintaining a strategic cash cushion equivalent to 3 to 12 months of living expenses reflects a prudent approach. However, the article emphasizes the need for a personalized plan that considers various factors, such as living expenses, income stability, stage of life, and risk tolerance.
Moreover, the acknowledgment that decisions around cash are both psychological and financial highlights the importance of a deliberate and personalized approach to cash management. The article suggests seeking assistance from trusted partners like Human Investing, underlining the value of professional advice in crafting a comprehensive financial plan.
In conclusion, the article effectively navigates through the complexities of cash management in the context of long-term financial planning. It provides evidence, historical data, and sound advice to underscore the importance of balancing cash holdings with diversified investments, ultimately helping investors mitigate the risks associated with inflation and achieve their financial goals.
