This Is One of the Biggest Mistakes an Investor Can Make

Photo: Pictures of Money, Flickr

The list of possible investing mistakes one can make is very long. You might invest in some doomed companies that implode. You might not invest in a company, despite thinking that it's destined to prosper. You might sell too soon, you might buy what you don't understand, you might get suckered into a penny-stock company with little revenue and no earnings. One of the worst mistakes to make, though, is keeping too much of your assets in cash.

The folks at Openfolio.com, a portfolio-sharing site, recently looked into how it was that roughly a quarter of investors lost money in 2014, a year when the S&P 500 gained more than 13%. After examining some 3,000 portfolios, they discovered that the investors who lost money had a lot of cash in their accounts -- nearly 20%.

The upside of cash
Having cash on hand isn't all bad, of course. It leaves you able to take advantage of opportunities that arise. If the market tanks, for example, it will present a lot of bargains, some of which you can buy into with your cash. This is one reason why Warren Buffett likes to keep a lot of cash on hand. He recently announced the purchase of Precision Castparts for $37 billion, much of that with cash, and expects to still have about $40 billion in cash after the deal closes. That's more than he'd like to have in cash, because holding a lot of cash has its downsides.

Having a lot of cash can give you a nice feeling, but it won't grow in value for you. Photo: Steven Depolo, Flickr

A downside of cash: opportunity cost
One downside of holding cash is opportunity cost -- an economic term referring to the opportunities you give up when you choose to do something. In this case, by keeping cash on hand, you're not deploying it in ways that can make it grow, such as investing it in various stocks or CDs. You're not spending it on a new car or a vacation, either, which are other opportunity costs.

Let's take a closer look at just how much you might be giving up. Imagine that you have a portfolio of $100,000 and it's invested in the stock market, where you hope to achieve the market's long-term annual average gain of close to 10%. Over 25 years, you can expect that $100,000 to grow to nearly $1.1 million. But let's say you like to keep about 20% of that portfolio, $20,000, in cash. What will the remaining $80,000 grow to over 25 years? $876,000, more than $200,000 less. Money sitting in cash is not effectively growing for you.

Keep in mind, too, that while the idea of having cash on hand in order to pounce on opportunities has merit, many people just don't execute that strategy well. You might have that cash on hand when the market tanks, but find yourself too chicken to buy at a time when so many others are selling. Alternatively, you may be a bit too greedy, passing up good entry points into great stocks because you're hoping share prices will fall even further. Overall, timing the market successfully, getting in and out of various investments at the right time, is easiest to do in retrospect. There's a strong case to be made to just stay fully invested, or close to fully invested in the market with your long-term dollars.

Another downside of cash: inflation
You might reason that you're keeping your cash in safe investments, not in coffee cans under your bed. Fine. But if your cash is sitting in a bank saving account or CD, earning 1% or even 2% annually, you're actually losing ground, due to inflation. Over long periods, inflation has averaged out to about 3% annually. Thus, any investments earning less than that are losing purchasing power for you. And anything growing at 3% annually is likely just retaining your purchasing power, without growing it for you.

Do be sure to build and maintain an emergency fund. Image: StockMonkeys.com

When keeping a lot of cash makes sense
There are some cases where it's smart to keep a cash hoard. Interest rates have been near historic lows for many years now, but there have been periods when banks and CDs have paid interest in the high single digits and even double digits. (The prime rate was in double digits, even topping 20%, between 1978-1985.) At such times, you can grow your money quite effectively in cash-like investments such as savings accounts and money market accounts -- as long as inflation is under control.

Another consideration is your emergency fund. Unless you're independently wealthy, you'll want to keep three to nine months' worth of living expenses on hand. Don't keep it literally in cash, such as in your mattress, but instead in cash-like, liquid investments, where you can access it easily and where it isn't likely to lose value -- such as in short-term CDs, savings accounts, and money market accounts.

Take a minute to think about how much of your overall assets are sitting in cash and whether you might want or need to move some of that into more promising long-term investments. Don't make the big mistake of missing out on a lot of growth because of having too much cash.