Holding cash can seem like a good idea, but it can be riskier than buying stocks

Many investors focus on market risk, particularly that the overall market will decline, leading to a loss of capital. Market risk is certainly an important consideration, but it’s not the only risk that investors face. There are a number of others to be aware of, including inflation, interest rate and currency risks. But there’s another one that many investors overlook: the risk of holding cash.

Cash may seem like a safe haven in uncertain times, but holding cash comes with its own set of risks. One of the biggest is inflation risk, which, given the current economic landscape, is especially relevant. Over time, inflation can erode the purchasing power of your cash, meaning you’ll be able to buy less with it in the future than you can today.

Some argue that holding cash is riskier than investing in stocks over the long term. Legendary investor Peter Lynch has said, “Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves.” This sentiment underscores the risk of trying to time the market by holding too much cash in anticipation of a downturn.

Here’s a simple calculation to illustrate the risk of holding cash versus stocks. Between 2011 and 2021, the return on cash (as measured by the annualized return of the three-month U.S. Treasury bill) was 0.47 per cent. If we adjust for inflation, which was 2.17 per cent on average during those 10 years, the return was minus 1.7 per cent.

Put simply, if you held US$100,000 in Treasury bills in 2011, you would have had US$84,243.26 of buying power 10 years later. Conversely, over the same 10-year period, a $100,000 investment in the S&P/TSX composite dividend index would have resulted in $200,797.37 of buying power, thanks to its inflation-adjusted annualized return of 7.22 per cent.

That’s not to say that holding cash always leaves you at a disadvantage. There is a time and place for retaining a certain amount of cash, particularly for immediate expenses or short-term financial needs. Yet if your cash is destined for future spending, then it should be invested accordingly.

Storing away cash for long periods is similar to voluntarily reducing your monthly savings or agreeing to lower your salary each year. Due to inflation, the buying power of your money gradually diminishes over time, as if the value of your savings is dwindling. Therefore, a strategic balance between immediate cash needs and long-term investments is crucial for a healthy financial future.

I believe the advantages of investing outweigh the perceived safety of holding cash. Investing isn’t just about expanding your wealth; it’s about preserving the value of what you already have against the persistent erosive effects of inflation.

There will always be a reason why “today” isn’t the best day to invest. However, the secret lies in understanding that investing is a long-term strategy; it’s not about speculating for short-term gains or simply parking your funds in cash. Investing comes with risks, but it is just as important that we analyze the risks of not investing.