Avoiding the cash trap

Cash is seen by most investors as the safest asset. But for high-net-worth investors, having too much cash in a portfolio can stop them from generating long-term wealth.

Data shows that the longer a portfolio is overweight cash, the more it will undermine performance. Over the two decades to 2023, the S&P 500 Index has returned an annual average of 10.2 per cent, with dividends reinvested. By contrast, the highest the Federal Funds Rate has reached during that period is 5.5 per cent.

“We are close to peak interest rates as major central banks are getting ready to cut,” says Winnie Kwan, equity portfolio manager at Capital Group. “You might find in one year’s time your cash rate will be lower, so you'll reinvest at a worse rate. It is time to diversify into equities and fixed income for better overall returns.”

Despite this, a Capital Group survey of high-net-worth investors shows that nearly four in five have more than 10 per cent of their portfolio in cash, while 90 per cent hold less than half their portfolio in equities, even as the S&P 500 reaches record highs.

But the survey also reveals that 11 per cent of investors consider the risk of holding cash over the next 10 years as "significant," a sentiment equally shared about bonds, with equities not far behind at 16 per cent.

Cash is still seen as safer

“Cash investments have outperformed bonds in the past three years,” says Kristen Bitterly, head of investment solutions Citi Global Wealth. “This anchoring in the most recent observations has investors continuing to believe that cash is an important part of an overall asset allocation and not fully considering the impact of reinvestment risk.”

Cash does not drop in nominal value, and about a fifth of investors in the Capital Group survey believe it delivers an adequate return. The surveyed investors are concerned that stocks (57 per cent) and bonds (41 per cent) will fall in value, although only about a third of them plan to buy if prices fall. When Capital Group asked why, 60 per cent fear higher volatility, 56 per cent expect faster inflation with a large minority (41 per cent) expect rate increases.

Investors see geopolitics as a major risk, causing 55 per cent to be increasingly uncertain about where to invest. “There is almost always some level of economic and geopolitical uncertainty. Because we all have 20:20 hindsight, it can easily feel like the past was very predictable, and only now do we face uncertainty,” says Mark Haefele, chief investment officer at UBS. To face that uncertainty - Haefele advises investors to retain portfolios that are globally diversified across a broad range of monetary blocs and financial assets within them.

Another important long term consideration is that the value of cash is subject to erosion from inflation. 

Cash tends to underperform

“There's always a reason not to invest, yet markets tend to go up as long as the economic growth outlook looks reasonable,” says Grace Peters, global head of investment strategy at J.P. Morgan Private Bank. “Cash doesn’t rally.”

That inability to rally is what creates the largest opportunity cost of holding cash for too long. Peters says that J.P. Morgan Private Bank’s long-term capital market assumptions put expected returns for in cash (US dollars) at just 2.9 per cent per annum, against 5.5 per cent for high-quality investment grade bonds and about 7 per cent for US large-cap equities.

“Over a 10-year period, you miss out on two-thirds of the investment return by sitting in cash,” says Peters. “That gives you a big loss of potential wealth.”

A fear of missing out should prompt more investors to put cash to work. Nearly two-thirds admit that they are bullish on equities, with one-third seeing good value. The same proportion see value in bonds and nearly half are considering increasing allocations, with a bias toward higher quality. Most experts advise buying both equities and bonds, as well as some alternative assets to benefit from diversification — which is a way to lower risk rather than boost returns.

Diversification pays long term

“From a longer-term perspective, it's very difficult to lose money on a well-diversified portfolio,” says Willem Sels, global chief investment officer at HSBC Global Private Banking and Wealth. “The probabilities of having positive returns that beat cash become better and better.”

With Fed rates at a 23-year high, bonds offer attractive yields that match or exceed cash rates, with the added benefit that their value will increase amid rate cuts. And coupon rates are fixed, whereas cash returns will drop alongside rates. If rates do not fall it suggests that the economy is stronger than expected, which will enhance earnings and support stock gains.

“Even in a year where the Fed was raising rates quite quickly and the global economy was slowing, a diversified portfolio outperformed cash with a relatively low volatility,” says Sels. “Our main conviction is to put cash to work either in bonds or diversified portfolios. Get out of cash and get invested.”

Rallies in bond and equity markets likely have further to run, particularly if as widely expected central banks cut interest rates. This means investors still have time to capitalise on any appreciation in these two major asset classes.