The big problem with ‘cash cushions’ and ‘dry powder’ in your investing portfolio

Got a comfy “cash cushion”? Is your portfolio packed with plenty of “dry powder”? When it comes to investing, I can only wish feeling safe and secure was as simple as that.

Cash feels safe – it’s got no short-term volatility. That balance in your savings account never goes down unless you make a withdrawal – right? The seeming certitude of cold, hard cash leads many investors to never question a habit of hoarding it.

You should. Carrying excess cash, whatever your “reason,” exposes you to invisible and insidious risk: Low-returning cash drags down long-term returns, risking a brutal, underfunded retirement. Let me explain – and give you tools to help right-size your coffers.

Holding some cash, maybe six to 12 months of expenses, is sensible – an emergency fund. It can make you a better investor, helping you avoid forced securities sales at inopportune times. Or, if there is an upcoming, major expense in the next several years (think: house down payment), cash set asides are wise. Anything volatile – stocks, bonds, etc. – is suboptimal in such scenarios.

Otherwise, cap your cash.

Myriad studies teach asset allocation – your mix of stocks, bonds, cash and other securities – determines most of your long-term return. Not market timing. Not stock picking. Not perceptions of “safety”. 

Your goals, needs and time horizon – how long your assets must last to finance your goals – should largely determine your allocation. Generally, the longer your time horizon and more growth you need, the bigger chunk you should have in high-returning categories, namely stocks. Maybe those taking cash flow or who vomit on volatility hold some bonds. But cash should be minimal.

Why? Minimal returns. Since good data started 100 years ago, US stocks annualized 10.3%. Gold, 6.4%. Quality, long-term corporate bonds, 5.7%. 10-year Treasurys, 4.7%. Cash? Treasury bills – a cash proxy – annualized lowest – at 3.4%. Averaging 3.0%, inflation ate up most of cash’s return.  If your goals require any growth, cash is least likely to deliver it.

So how much cash do you hold? What is your asset allocation? Too many investors don’t know. To size them up, start thinking asset class – not account or “bucket.”

Add your 401(k), IRAs, after-tax accounts – any savings or CDs. Stocks, ETFs, whatever. Put it all together. What is cash as a percent? 

Own blended or target-date funds? Dig into the weights. If you have $100,000 in a 60% stock, 40% bond fund, chalk $60,000 to stocks, $40,000 to bonds.

Then subtract funds earmarked for known, near-term expenses or emergencies. Divide each category – stocks, bonds, cash and other – by the total. The resulting percentages are your allocation.

Conscious or no, your allocation may reveal an implied forecast. If you over-hold cash, you are saying history’s lowest-returning asset class is more future fit than higher-returning ones. In other words: uber-bearish.

Is that intentional? If so, to justify it you need to see big negatives that others don’t – that markets haven’t already priced in. 

Many say they hold cash “in case” stocks tumble. But what’s the cost of all that cash? Usually those investors hold “dry powder” long term. Terrified, they don’t take advantage of “buy the dip opportunities” like early-April offered. They ignore cash’s performance, focusing on portfolio parts versus the whole. 

This mental accounting that sidesteps total allocation percentages is a psychological error. Big cash holdings feel good. But they cause pain when it comes to overall returns in the intermediate to long term.

Since 2000 (a cyclical stock market peak), $100,000 invested in 70% US stocks and 30% long-term Treasurys grew to $522,621. Stash 20% in cash, and you wound up with $70,000 less. And that’s despite a big, full three-year bear market start. 

The bottom line: Cash is costly. Think about your total holdings and asset allocation. Think about any big-ticket life situations and emergencies. And cut your cash balance to the bone.

Ken Fisher is the founder and executive chairman of Fisher Investments, a four-time New York Times bestselling author, and regular columnist in 21 countries globally.