People keep lots of money in cash instruments -- savings accounts, money market funds, certificates of deposit, and the like. It makes sense because it's secure and reliable, and after the economic panic that was 2008, you really can't blame investors for wanting a little bit of financial security. After all, cash truly is a low-risk investment, right?
You may change your mind
When you compare stocks and cash, one thing is clear: Cash is much less volatile. That means you can expect a definitive amount of certainty with your cash investment. This much we know for sure.
The craziness of the past couple of years has sent many investors flocking to the perceived safety the greenback offers. This makes sense for some people who are retired or who want to keep conservative portfolios; owning shares of riskier companies like First Solar (Nasdaq: FSLR ) or Gilead Sciences (Nasdaq: GILD ) would obviously not be the smartest idea. The same can probably be said for buying junk bond funds that hold debt from companies like Ford Motor (NYSE: F ) or NRG Energy (NYSE: NRG ) .
However, oftentimes cash can pose a greater risk to your portfolio than any group of stocks -- risks that can seriously damage your chances of a sound retirement.
Here's $12 for 45 years
American households hold $7.7 trillion in cash or cash equivalent deposits. That's more than the $4.8 trillion held in equity mutual funds, and way more than the $2.2 trillion held in bond funds. A Wall Street Journal article by Brett Arends took a closer look at what's going on with all that hard-earned money.
Since 1964, money held in short-term, safe accounts has earned an average of about 6.15%. So someone who put $100 away 45 years ago would be holding onto $1,600 today. That sounds pretty darn good. But of course that doesn't take into consideration inflation -- over the same time period, the dollar has lost about 86% of its purchasing power. So truthfully, that $100 investment would yield only about $220 in today's dollars.
Wait -- let's not forget about taxes. Imagine you are in the 15% tax bracket. After taxes are withheld and after inflation is considered, your investment is now down to about $146. That's less than a 1% annual return.
Now let's imagine that you're in the 25% tax bracket. After modifying for inflation, your tax-adjusted total investment comes to a whopping $112. After 45 years, your initial $100 has churned out 12 bucks. As Arends so eloquently stated, it's like saying "Don't enjoy your money today. Tuck it away for half a century, till you're old and grey -- and we'll pay you an extra $12."
Keep a level head in a rickety market
If you're a firm believer that cash is king, you may be totally depressed right now. There's good reason; cash has some really severe setbacks. And unfortunately I can't lie to you and say that stocks are anywhere close to risk-free. Even reliable companies like Abbott Laboratories (NYSE: ABT ) -- which has returned 13% annually over the past 20 years -- carry risk. It has fallen 40% in value twice in that period! But next time someone tells you that your cash is "risk-free," remember that cash bears great risk, as The Wall Street Journal pointed out.
Now this doesn't mean you shouldn't have some of your money in cash -- most financial advisors will suggest you have at least six months of an emergency fund parked in the most liquid of assets. But if this crazy market has driven you to move into cash as a long-term investment strategy ... well, that's a recipe for disaster!
It's normal to feel hesitant if you've been burned and can still see the scars from 2008, but you need to remember that cycles come and go, and keeping the course with a proper allocation of stocks is crucial for a sound retirement. If you're looking for safety but understand the necessity of staying in the market, the best idea is to buy well-established dividend stocks, such as those suggested by our Income Investor team -- it's a great way to boost returns while staying within the "safe" category.
Our team of analysts recommends companies that provide you with streams of fixed income, room for growth, and limited downside. They suggest companies that have paid dividends for many years, like Johnson & Johnson (NYSE: JNJ ) and PepsiCo (NYSE: PEP ) .
Income Investor probably won't make you filthy rich or achieve 20% returns every year, but it will help secure your financial future in a way that cash cannot. Since inception, the team has beaten the S&P 500 by more than 7 percentage points. If you're tired of receiving terrible long-term returns and want a safe way to prepare for your retirement, you might be an excellent candidate for Income Investor. Right now you can be a guest of our service, free for 30 days. Feel free to click here for more information.
Fool contributor Jordan DiPietro owns shares of First Solar, which is a Motley Fool Rule Breakers selection. Ford Motor is a Motley Fool Stock Advisor pick. Johnson & Johnson and PepsiCo are Motley Fool Income Investor choices. Motley Fool Options has recommended a buy calls position on Johnson & Johnson. Motley Fool Options has recommended a diagonal call position on PepsiCo. The Fool's disclosure policy wants nothing more than a relaxed retirement.