4 ways cash drags down investors’ portfolios

It’s pretty plain and simple: Cash is not a good investment for anything other than the very short term. After taxes, inflation and its current expected return (zero), you are actually losing money when you hold cash in your investment portfolio over the long term. In other words, cash is a drag on your returns.

We’re hardly the only investment manager to take this stance. In a research paper published in Financial Analysts Journal last year, Vanguard founder John Bogle cited cash drag as one of the ways investors are not making the most of their investments.

(Read the counterpoint: Schwab makes its case for using cash in its automated portfolios)

Cash costs investors returns

Many investment services offer the option to hold cash in your account, but very few force you to. In practice, your cash holdings could range from a tiny fraction of your balance to a substantive allocation in your portfolio. Most often this cash is there due to inefficiency — an investor is waiting to have enough money to justify the expense of buying a set of whole shares. For active managers, it can be there as “dry powder” waiting for a buying opportunity.

Across the universe of U.S. equity mutual funds, Morningstar Inc. calculated an average cash weighting of 3.2%. As Mr. Bogle noted in his paper, index-tracking funds tend to carry a lower cash load than active funds, as they don’t need any dry powder.

(Related read: Low mutual fund cash levels don’t tell the whole story)

Either way, it’s money on the sidelines. And investors should be pursuing a higher level of efficiency — cash drag zero. In the modern age, you can use fractional shares to ensure clients’ money is never sitting uninvested.

Charles Schwab & Co.’s new automated portfolio brings inefficiency to a new level. Its offering, Schwab Intelligent Portfolios, requires a cash position from a minimum of 6% to as much as 30%, according to Schwab’s disclosures. Schwab admits that this is because it’s how it makes money on the platform, but it creates a strong conflict of interest. Cash holdings in Schwab’s 2050 target date fund are 3%, less than half as much as what’s in its most aggressive Intelligent Portfolios mix.

(More: Exclusive: Schwab robo-adviser crosses half-billion dollar mark)

It’s one thing to have its customers keep a small amount of cash on the side because it isn’t able to do fractional share trading. It’s another when it’s because it’s the most profitable part of a customer’s portfolio.
For the smart investor, there are four big red flags here.

1. You’re not earning returns, and are losing money.

First, the most obvious issue is that cash is simply not a real risk-free investment and doesn’t belong in any moderate to long-term investment portfolio. It currently returns almost zero, and when you factor in inflation, it can lose you money. That means the more cash in your portfolio, and the longer you invest, the less your portfolio may be worth compared to a portfolio without cash. This is especially deceptive when advisers talk about cash without adjusting for inflation.

While a small portion of cash, for example an allocation of 6%, may seem like an insignificant amount, it still can be a significant drag on returns. This is especially true for a long-term investor who should be in a high-stock allocation.

2. It’s a conflict of interest.

A forced holding in cash for long-term investors should raise eyebrows. This is particularly important when it comes to a portfolio that is billed as “free.”

Schwab is marketing its new portfolio as “free,” yet there exists a very real underlying cost hidden in the allocation structure. Investors are paying a hidden fee via the cash allocation they are forced to hold. How does that work?

In Schwab’s fine print, Schwab is explicit that it will use cash, held in its company’s bank, for its own investing, providing them with revenue and reducing investors’ expected returns.

Herein lies the conflict of interest: As a customer, you now have a portfolio manager who is incentivized to have you hold more cash than might be optimal for your investment strategy — simply because they make more money on it. Schwab even acknowledges this conflict of interest in its recent filing with the U.S. Securities and Exchange Commission, specifically calling out that not even other Schwab entities would allocate so much of a portfolio to cash: “In most of the investment strategies, the percentage of the Sweep Allocation is higher than the cash allocation would be in a similar strategy in a managed account program sponsored by a Schwab entity or third parties. This is because … clients do not pay a Program fee.”
This conflict can have some unexpected consequences. For instance: such an allocation to cash might feel intuitively sensible because of a mental association with a “rainy day” fund.

With an enforced cash allocation, such as Schwab’s, you will never be able to withdraw just the cash if a rainy day does come. Since the cash allocation is the backdoor method by which Schwab gets paid, the service would rebalance you back into the target cash allocation, selling securities in the process, and possibly triggering capital gains. From the same filing:    “[Schwab] may terminate a client from the Program for withdrawing cash from their account that brings their account balance below the minimum…”
If you want some cash on the side, this is not it; you’ll need another cash stash in your bank account, both costing you returns over the long term.

3. You can better manage risk with bonds.

“But cash is safe,”’ I hear you say. “It helps stabilize the portfolio.”

“Actually so do bonds,” I say. “And they don’t reduce your expected real returns like cash does.”

The vast majority of the time, you’ll be better off using bonds rather than cash. You can achieve both the lower drawdown risk while protecting against inflation risk with high-quality inflation-protected bond funds, such as the Vanguard Short-Term Inflation-Protected Securities.

The chart below depicts the rolling two-year real returns of a basket of five-year Treasury bonds versus a cash savings account.
https://s32566.pcdn.co/wp-content/uploads/assets/graphics src=”/wp-content/uploads2015/03/CI98959331.JPG”

When assessed properly (at a portfolio level), Treasury bonds have dominated cash for any non-immediate time horizon. Even through the 2008 financial crisis, you would have been better off investing in Treasury bonds than cash. Critically, bonds tend to rally when stocks are crashing, a process called the “flight to quality.” Cash cannot experience price appreciation — bonds can.

(Also: Schwab retains forced cash allocation for institutional robo platform)

Moreover, it’s not just the frequency with which bonds win but also the extent of the advantage. Let’s look at the cumulative performance of a portfolio of stocks and Treasury bonds versus a portfolio of stocks and cash savings since 1955. It turns out that investing in a $100,000 portfolio of stocks and Treasury bonds in 1955 would have outperformed the same stock portfolio with cash by $44,013.
https://s32566.pcdn.co/wp-content/uploads/assets/graphics src=”/wp-content/uploads2015/03/CI98960331.JPG”

4. It’s archaic inefficiency, not modern efficiency.

Lastly, let’s talk about efficiency. As you may know, trading on an exchange only happens in round, whole share amounts. And dividends and coupons pay cash into your brokerage account. The result is a little bit of cash permanently left on the side. This is not an efficient way to do things.
Imagine that you have a portfolio with 12 ETFs, and one share of each ETF costs $100. Now, you make a $90 deposit (or your ETFs pay a total of $90 of dividends). With a platform that only uses whole shares, you cannot use any of that cash to add to your investments because it’s not enough to buy a single share of anything. So that $90 will remain uninvested, waiting for additional cash, before you can buy even a single share.

As deposits and dividends flow through this account over time, it will always have some amount of pesky cash remainder sitting there. This is suboptimal investing.

In the end, it’s important to understand the role investing has in your financial plan — and the role cash plays. When you pay for investments, whether that’s through an expense ratio or a management fee, you’re paying for the potential to earn returns, not to lose money with cash.

If you’re comfortable keeping cash on the side, remember, you can always use a savings account.

Dan Egan is the director of behavioral finance and investing at Betterment.

Related Topics: Charles Schwab & Co.