The Opportunity Cost of Holding Cash

Posted by Jacob Radke

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It is my belief that part of the 2023 rally has been driven by people who sold and held cash in 2022 that are now saying boo and realizing that they have to get back in the market before they lose potentially more of the rally’s upside.

It was nobody’s prediction that the Nasdaq would be up 30%+ this year, and so people we’re fine with 4.5% money market yields until the outlook resolved itself.

You took less risk, and it wasn’t like the reward on the other side was completely obvious.

People hit ultimate bearishness and held cash, then held that belief, and when the market started rallying again, they missed it.

I’ll say it again for everyone out there. WHEN YOU HOLD CASH YOU ARE ACCIDENTALLY TIMING THE MARKET.

What Is Market Timing and Why Is It Risky?

Market timing is the strategy of trying to predict the future direction of the market and buying or selling stocks accordingly. It sounds appealing in theory, but it’s very difficult to do in practice.

I believe the market is about 30-40% human emotion and about 60-70% hard numbers. That means that even if the hard numbers are looking great, human emotion can still cause panic selling, missed opportunities, and of course excessive exuberance.

It doesn’t matter how great something is, it only becomes valuable when everyone believes it has value.

Market timing involves emotional decision-making, which can lead to costly mistakes.

You may sell your stocks when the market is down because you’re afraid of losing more money, or you may buy stocks when the market is up because you’re afraid of missing out on the gains.

How Holding Cash Can Hurt Your Returns

You may think that holding cash is a safe and conservative way to protect your money from market fluctuations. But in reality, holding cash can hurt your returns in several ways:

  • You miss out on the opportunity of investing in the market. The market tends to go up more than it goes down over time, so by staying on the sidelines, you’re giving up the potential growth of your portfolio.
  • You lose purchasing power due to inflation. The value of cash decreases over time as the prices of goods and services increase. You’re 4.5% money market yield would have been completely eaten away by the 5%+ average inflation over that time.
  • You pay taxes on your nominal interest income. If you hold cash in a savings account or a money market fund, you’ll earn some interest income, but you’ll also have to pay taxes on it. This reduces your net return even further - granted you’ll still have to pay taxes on the capital gains and investment income in other markets.

Here is a hypothetical example of how this works, keep in mind that no know has a crystal ball, including and especially me. Suppose you sold and held cash in June 2022 and decided to keep it until June 2023. Here’s what would have happened:

Sure the guy who decided that cash was a great investment in June missed the extra downside… good for him. But the guy who just held through is in a much better spot, and if he didn’t really watch his statements like a hawk he’s probably not mentally feeling so bad.

Another consideration here is that the guy who is holding cash for 12 months knows that he at some point wants to get back into the market (market timing). What happens if he decided that in July 2022 after the insane rally was the time to get back in. He would be even further behind than the guy who is fully invested. This guy holding cash has to be completely emotionless about investing. He can’t get FOMO and he can’t be irrational.

What Could You Do Instead of Holding Cash?

If holding cash is a bad idea for long-term investors, what could you do instead? Here are some tips:

  • Invest according to your risk tolerance and time horizon. Don’t let fear or greed dictate your investment decisions. Instead, choose an asset allocation that suits your risk tolerance and time horizon. For example, if you’re young and have a long time until retirement, you maybe can afford to invest more aggressively in stocks than if you’re older and need income soon.
  • Diversify your portfolio across different asset classes and sectors. Don’t put all your eggs in one basket. You can reduce your exposure to any single market risk and benefit from the performance of various markets.
  • Rebalance your portfolio periodically. Don’t let your portfolio drift away from your target asset allocation. Instead, rebalance your portfolio periodically, such as once a year or when your allocation deviates by more than 5%. This way, you can maintain your desired risk level and take advantage of market fluctuations by selling high and buying low.
  • Stay invested for the long term. Don’t try to time the market or chase short-term returns. Instead, stay invested for the long term and focus on your long-term goals. This way, you can avoid emotional mistakes and benefit from the power of compounding.

Here’s the point. The longer and more often you hold cash the better investor you need to be, because you will simply win some and lose some than the guys who’s in it for the long haul, going up and down right along with the market.

By the way we are only looking at one market here, the US stock market. There are endless markets around the world, endless possible investments you can make. Choosing which ones to allocate more to and which to allocate nothing to becomes increasingly challenging.

The simplest solution is buying haystack, because you’ll always find the needle, but that may not always be the best option for your goals.

Your financial life is much more than your portfolio balance, and you should treat it that way.

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