The Pros & Cons of Investing in Cash

Cash appears to be a safe investment to many investors, and that is true in a sense. The nominal value of your savings will not go down if you hold cash. But some investors use it in a way that detracts from their ability to reach their long-term goals, either by holding onto it over a long period of time, which erodes the value of their savings, or by using it as an alternative to riskier assets when the market feels risky, which can cause them to miss out on some of the best available returns.

Cash is good for money you’re going to spend, but is generally a bad investment. Here are a few things to remember:

1. Cash is great for short-term savings

2. Cash will lose value over time

3. Investing is a better bet for long-term savings

4. Cash is a bad bet when the market feels risky

Cash is great for short-term savings

If you’re going to need most or all of your savings within the next three years or so — say for a downpayment, or for tuition payments — cash is a great place to put it. Outside of short-term goals, it can be a good idea to keep a few months’ expenses in cash for emergencies. The point is, it’s a good way to make payments.

Cash will lose value over time

When you hold cash, you’re guaranteed to lose a little bit each year thanks to inflation. Interest rates (the rate at which you earn money on your cash) are below the rate of inflation (the rate at which the prices of the things you buy increase). They are expected to remain that way for the foreseeable future. Savings held in cash for 5-10 years are expected to lose somewhere between 5-15% of their value.

Source: Bank of Canada, July 27 2020. [1]

Investing is a better bet for long-term savings

While cash is safer in the short term, but loses value in the long term, the opposite is true for an investment portfolio. In the short term, it can fluctuate, but it’s expected to increase in value over time (here’s a deeper explanation of why that is). If you don’t need your savings in the next few years, history and logic show that a diversified portfolio — the kind that is available through Wealthsimple Invest — is the best way to grow it.

Below, we show the historical returns of cash against the returns of a simple portfolio of 50% world stocks and 50% 10-year Canadian government bonds, simulated back to 1925. We show the real (i.e., after inflation) returns over periods of 3, 5, 10, and 20 years. You can see that our simple portfolio has an excellent chance of outearning cash over 3 years, and the chances of outperforming only increase as time goes on.

Source: Global Financial Data, Wealthsimple Analysis. [2]

Cash is a bad bet when the market feels risky

And it gets worse: if you don’t hold stocks when the economy feels very risky, you can miss a lot of the returns. The economy moves in a cycle. Sometimes it expands, and sometimes it contracts. Stock returns generally anticipate these changes, and will offer high returns before things are obviously improving. When you start to read about economic growth in the newspaper, some great returns are often gone. Stocks tend to offer lower returns (but still better than cash) when the economy has been growing for a while or just before the economy contracts.

Source: DeStefano, “Stock Returns and the Business Cycle” [3]

This is a volatile ride, but over time you achieve the attractive returns we showed above in our simple portfolios. If you allocate to cash away from stocks when it feels scary (i.e., in a recession when all the headlines are bad), you may lock in losses and miss the best times to own stocks.

We hope this helps you reflect on the benefits and drawbacks of cash as a financial asset. Our key points are:

1. Cash is great for short-term savings

2. Cash will lose value over time

3. Investing is a better bet for long-term savings

4. Cash is a bad bet when the market feels risky

Disclosures

Sources: Bloomberg, Global Financial Data, Bank of Canada, DeStefano “Stock Returns and. the Business Cycle, Wealthsimple analysis.

Disclosure: All charts and tables are for illustrative purposes only and are not the returns of an actual account. Past performance is. not determinative of future results, actual results and probabilities will differ.

• Note 1: This chart shows cash interest rates, the core Canada Consumer Price Index, and the Bank of Canada’s long-term inflation target.

• Note 2: This chart shows the returns of rolling Canada 10 year bonds, and the Global Financial Data Developed World Index, rebalanced monthly, gross of tax and transaction costs, less the Canada Core CPI.

• Note 3: From DeStefano, “Stock Returns and the Business Cycle”, The Financial Review 39 (2004) 527–547.