Rule #1: Cash is Not King

There is much talk about how cash is king.  Cash is king when you can’t pay your bills.  Cash is king if you’re starving and need a hot dog.  It is king when you have liquidity problems.

Cash rules when you can’t meet your financial commitments.

The truth is you only want to keep enough cash on hand to meet your obligations – mortgage, ongoing expenses, and a buffer for unforeseen costs.  Having all your assets denominated in cash for long periods is one of the worst things you can do. Especially, with the budget and trade deficits of U.S. which will push up inflation.

Historically, inflation averages about 2.5% per year. Again, could be worse – much worse – if the U.S. government and its consumers don’t get spending under control.  Now if you hold all your money in cash for thirty years and risk nothing, your real return will be -53%.   You might say to yourself, I’m not taking any risk and that allows me to sleep at night (albeit with cash rotting under your mattress).  But however you look at it, stewarding your money for 30 years only to lose more than half of its buying power is not what you would call a value proposition.

An alternative is to invest in certificates of deposit (CD’s) backed by the FDIC.  From 1970 to 1999 the real rate of return (nominal return – less inflation) is +2.5%.  This does not take tax into consideration. (However, make no mistake only two things are certain in life, death and taxes.)  At a 2.5% compounded annual return, your return after inflation is +109.8% over 30 years.  Better than negative return, but by no means great.

Now let’s say you bought a basket of stocks from the S&P 500 and held it for the same period.  Over the last 40 years the S&P has returned 11.5%.  If we take 11.5% as our benchmark and deduct expected inflation of 2.5%, our real rate of return will be 9.0%.  Compounding at this rate will give you a real return of +1226.8% over 30 years.  Now, that’s something to get excited about.

While these examples are simplified (it doesn’t take into account market risk, risk-adjusted returns or other products like bonds, treasuries, or hybrid investments) – it is clear holding cash overtime is a losing currency.

The key is to buy assets intelligently.  Overtime, if allocate your money wisely you can build a nest egg to provide for you now and later (retirement).  You might even leave some behind for the little ones.

By |2018-12-13T08:34:24+00:00May 19th, 2010|Uncategorized|