Thought of the day

Central banks increased interest rates sharply in 2022. The Federal Reserve lifted the fed funds rate by 425 basis points, and the European Central Bank and Swiss National Bank increased policy rates by 250bps and 175bps, respectively, ending the era of negative rates.

As a result, nominal cash returns look more attractive. But saving large sums in cash in anticipation of major purchases—rather than staying invested and standing ready to borrow on your portfolio—can be a mistake for a few reasons:

  • Cash drag. Historically, excess cash has been worse than a deadweight on portfolios. Since 2000, cash in US dollars would have lost around 43% of its real spending power, while cash in euros would have lost 37%. A Swiss franc account would have provided zero real return. While inflation has been subsiding in recent months in most of the world, the real spending power of cash savings is still being eroded at close to the fastest pace in decades.
  • The downside from not being in the market. Selling part or all of an investment portfolio, or simply saving in cash for future purchases, imposes a significant opportunity cost. Of course, cash deposits can outperform equities over short periods. Historically, in any single month, cash deposits have had a 40% chance of beating stocks. But this goes down to 13% over a decade and falls close to 0% over 20-year time horizons. And the magnitude by which stocks have beaten cash is large—a median of about 9 percentage points per year since 1928.
  • The perils of market timing. Seeking to time the market typically lowers returns relative to buy-and-hold investing. Selling down a portfolio to fund big-ticket items is a form of market timing—even if it is based on spending needs rather than on an explicit view of the market. Moreover, an ill-timed portfolio sale can have a meaningful negative impact on longer-term portfolio growth. For example, the second quarter of 2009 accounted for a significant share of returns for the subsequent decade. Missing this quarter alone would have lowered returns from 532% to 446% based on S&P 500 performance.

So, we recommend setting aside a Liquidity* strategy that is funded with resources to meet the portfolio's cash flow for 3–5 years—the time that it has historically taken markets and portfolios to fully recover from even the worst bear market losses. This is preferable to holding excess cash reserves, which are losing purchasing power at close to the fastest pace in decades.

Borrowing can also make sense under some circumstances, including where the alternative is selling potentially high-return assets after the recent sell-off in stocks and bonds. The cost of borrowing has gone up over the last year, but so too has the expected return on portfolios after poor stock and bond performance in 2022. So, we also recommend that investors complement their Liquidity strategy assets by reserving borrowing capacity for future planned spending within the 3–5-year time horizon, for example by using securities-backed lending. As with any form of credit, securities-backed loans involve risks, including over borrowing and margin calls.

*Timeframes may vary. Strategies are subject to individual client goals, objectives and suitability. This approach is not a promise or guarantee that wealth, or any financial results, can or will be achieved.