As the Standard & Poor's 500 seems to be moving higher almost every day, the dangers of investors chasing the market higher in an attempt to ensure they do not miss out on future gains. This is a dangerous prospect, and even though interest rates remain at some of the lowest levels in history, the value of cash still needs to be appreciated.
One of the most common arguments among inexperienced investors today is that with cash returning 0%, the best course of action to achieve higher returns on your money is to invest in equities. While correct to a certain extent, the value of cash can never be underestimated. Even though money in the bank may return 0% today, the optionality of having that cash on the sidelines, ready to deploy at any moment, is invaluable.
The opportunity cost of uninvested cash
The opportunity cost of uninvested cash is hard to calculate. Cash is itself a position and waiting for the opportune moment to invest is probably one of the most important parts of investing. Just jumping into the market because stocks are heading higher is not a valid investment strategy. Instead, waiting on the sidelines for a better opportunity may be the better course of action to take, even though in the near term it may not appear so.
One of the best ways to show how valuable cash is is to use an example. In this scenario, let’s say you have $1,000 in the bank earning 0% in interest every year. In an attempt to generate better returns, you invest this money in an S&P 500 tracker fund. Today the S&P 500 is considered to be trading at one of its most expensive valuations ever, and Wall Street consensus is that the index will return midsingle-digit returns over the next few years based on past trading figures from current valuation levels. A midsingle-digit return per annum may seem attractive compared to the 0% on offer from a bank, but by waiting for the next bear market, you may be able to generate high teens returns every year if you invest near the bottom of the market. Because bear markets occur every decade or so, waiting a few years to increase your potential returns by three times is an attractive bet.
Don't discount psychology
But there’s much more to the cash argument and just being able to invest at the bottom of the market (considering market timing is almost impossible as well the benefits of such a strategy may be limited). More importantly, there’s a psychological benefit to holding cash, which may not be immediately apparent.
The psychological benefits of having a large cash balance should not be underestimated. As mentioned above, cash gives optionality –Â the optionality to do what you want when you want. The market is an unpredictable and uncontrollable beast; to make sure you’re not pressured into making any portfolio adjustments with which you don’t agree, you need financial headroom, and this is exactly what cash gives. At the same time, if you find yourself staring at a large portfolio loss you can use cash holdings to make selective acquisitions and improve long-term performance by averaging down. Put simply; cash means you can manage your portfolio the way you see fit and not how the market dictates.
The bottom line
Overall, it may seem tempting to take cash earning 0% and invest it, in an attempt to achieve a higher return on your money but this strategy is flawed. While it might be possible to generate a higher monetary return, the psychological and optionality costs of holding cash are impossible to quantify for this reason cash should not be underestimated.
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