Cash is Riskless! Well, Not Exactly
December 16, 2019 | Stanley K. Himeno-Okamoto, CFP®, CFA
When people think of safe, no-risk places to park their money, banks are often the first places that come to mind. As long as your bank deposits are covered under the FDIC's limits ($250,000 in 2019) and barring a Great Depression-esque bank run that drains the FDIC's assets and maxes out its line of credit (we'll ignore these scenarios), a dollar deposited can always be withdrawn for the exact same value: one dollar (plus a little interest). Sounds like the definition of riskless! You can't lose money by putting money in the bank.
But, the key word is "value". What exactly does "value" mean? Above, I used it in a nominal sense: one dollar is one dollar, whether we're talking about today, five years from now, or 100 years ago. In reality, the true value or purchasing power of money degrades over time. My grandma used to tell me a loaf of bread cost a nickel and a gallon of milk was 10 cents when she was a kid. Can you think of anything that can be bought for a nickel or dime today? Certainly not a whole loaf of bread or gallon of milk. This illustrates how the "real" value of money degrades over time – through cost inflation. If we use the U.S. Federal Reserve’s target inflation rate for illustrative purposes, your money loses about 2% of its “real” value every year.
The point is, money in the bank is "safe" and "riskless" in the sense that whatever dollar amount you put in you'll be able to withdraw. But with interest rates for even the highest-yielding savings accounts below 2% today, and with many traditional banks offering rates below 0.25%, you run the risk of inflation cutting the value of your money more than the interest paid can offset it.
If your intention is to hold onto a significant amount of cash in expectation of a near-term expense (setting aside a down payment for a new home in a year, for example) or have an emergency fund covering several months of expected expenses, that's smart planning. But if the money set aside for your retirement 20 years from now is sitting in cash, you might find yourself perpetually fighting inflation as you try to save enough to stay on track to retire. That's not to say you should invest entirely in stocks or only in assets with the highest expected rates of return. Higher expected risk accompanies higher expected returns as investors demand compensation for taking on more risk. Understanding your risk tolerance will allow you to strike a balance between risk and return, allowing you to generate the greatest expected return using your entire risk budget and building a portfolio consistent with your risk goals.
We've found using risk-analysis tools to help clients determine their risk tolerance has been greatly beneficial, especially given the extended bull market we've experienced since the 2008 Financial Crisis. With historically low volatility and few market corrections, some investors have increased risk considerably to take advantage of the seemingly endless upward trend of U.S. Markets at no consequence – until the inevitable next downturn. On the other hand, many investors have been very fearful of volatility and losing money; they remember the pain of 2008 where their riskier portfolio suffered and therefore avoided investing for much of the market’s recovery and expansion.
Having a portfolio consistent with your risk tolerance and financial situation is important. Too much or too little cash can introduce unexpected risks, and investing outside of your risk budget can result in excess risk or insufficient returns. If you’d like to learn more about your risk tolerance or would like a complimentary portfolio review, send us an email or schedule time to talk to a ClearPath financial planner.
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