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Traders work on the floor of the New York Stock Exchange shortly after the market opening in New York July 11, 2013. A quick look at historical returns show just how dangerous holding too much cash can be for an investor – and the reasons involve inflation and taxes. (LUCAS JACKSON/REUTERS)
Traders work on the floor of the New York Stock Exchange shortly after the market opening in New York July 11, 2013. A quick look at historical returns show just how dangerous holding too much cash can be for an investor – and the reasons involve inflation and taxes. (LUCAS JACKSON/REUTERS)

Strategy

Beware the stagnant cash collecting dust under the bed Add to ...

A slowdown in China, lingering problems in Europe, the unknown landscape of a post-QE environment – everywhere you look in the investment world these days, the talk is about one frightening risk or another.

All this, combined with a hangover from 2007-2008 bear market, is enough to make you want to pull your money out of stocks and shove it under your mattress.

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The problem is that the biggest risk of all may lie underneath that proverbial mattress.

I realize this sounds like the kind of thing investment advisers say when trying to sell you something. But the data back it up.

A quick look at historical returns show just how dangerous holding too much cash can be for an investor – and the reasons involve inflation and taxes. According to data from BlackRock Morningstar, and the Tax Foundation, stocks averaged annual compound returns of 9.8 per cent from 1926 through 2012. After inflation, however, the return fell to 6.7 per cent. And after taxes are also factored in, the average returns were 4.5 per cent.

If you think that’s disappointing, look at bonds. They averaged a compound annual return of 5.4 per cent over that period – not bad at all. After inflation, however, the figure dips to just 2.3 per cent. After taxes? A paltry 0.6 per cent.

Still, at least that paltry 0.6 per cent means bond investors took home something after inflation and taxes. While conventional wisdom is that you can’t lose money you put in the bank, that is exactly what has happened to cash holders over the long haul.

In that 1926-2012 period, cash earned a nominal average compound return of 3.5 per cent. After inflation, it earned just 0.5 per cent. Throw in taxes, and the return on cash turns negative, at minus 0.8 per cent.

Of course, cash can help you if your timing is right. Had you moved to cash in late 2007 or before September, 2008, you would have sidestepped some huge losses. But that means that a) you were able to predict a once-in-a-lifetime-type market shock, and b) you knew roughly when that shock would occur – and when it would end.

Rather than timing things just right, many investors did the opposite. They jumped out of the market only after major declines had occurred, and got back in only after major gains had resumed.

Poor timing decisions like that can hammer returns. Dalbar Inc. found that in the 20 years ending at the end of 2012, the S&P 500 averaged 8.21 per cent annual returns, and the Barclays Aggregate Bond Index averaged 6.34 per cent. Average equity fund investors, however, earned just 4.25 per cent annualized, while average fixed-income fund investors earned just 0.98 per cent.

The reason: Investors tend to exercise terrible timing in their decisions about jumping in and out of both equity and bond funds.

So what should you do? One strategy is to calmly assess the forces that you can be sure will corrode your results.

Taxes, you can be sure, aren’t going to disappear any time soon. And as for inflation, yes, it is quite tame now, but don’t expect that to last forever.

David Dreman, the Canada-born investment guru, noted in his classic book Contrarian Investment Strategies that “an all-encompassing strain of risk permanently entered the investment environment for the first time after World War II. The virulent new risk is called inflation. Nothing is safe from this virus, although its major victims are savings accounts, T-bills, bonds, and other types of fixed-income investments.”

Because of inflation, Mr. Dreman said those who think holding cash is the safe course of action are deluding themselves – a difficult notion to accept for many of us. “Indeed,” he writes, “it goes against the principle we were taught from childhood – that the safest way to save was putting our money in the bank.”

To be clear, I’m not saying that cash is bad thing. Most investors should probably have some cash on hand – Warren Buffett always has some cash available in case good opportunities pop up. And I want to stress that, depending on your age and personal situation – especially if you’ll be needing your money relatively soon – you should probably have quite a bit. But, for investors who are trying to build wealth over the long haul, fleeing to cash at times like these either because of fear or because you’re trying to outsmart the market can end up backfiring.

One way to keep yourself from jumping to cash at just the wrong time is known as dollar-cost averaging. By setting aside a fixed amount of money and investing that money in stocks at a regular interval (such as every month), you force yourself to be disciplined. The strategy also means you automatically buy more shares when prices are low and fewer shares when prices are high.

Over the long haul, stocks have proven to be the best investment vehicle – if you stick with them. That’s hard to do at times like these, when fear is prominent in investors’ minds. But if you forget what history has shown and get too cash-happy, you may leave yourself exposed to the greater risk of not reaching your long-term goals.

John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the Omega Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service.

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