Why Playing It Safe Is Far Riskier Than You Think
When it comes to investing, one of the most common approaches is to play it safe by holding a significant portion of your wealth in cash. After all, cash is stable, accessible, and free from the volatility that often accompanies the stock market or other investment vehicles.
But while it may seem like a prudent choice, keeping your investments in cash over the long term is far riskier than you might think.
The primary culprit? Inflation.
The Erosion of Purchasing Power
Inflation is the rate at which the general level of prices for goods and services rises, leading to a decline in purchasing power over time. Essentially, as inflation increases, each dollar you hold buys fewer goods and services than it did before. This gradual erosion of purchasing power is one of the most insidious risks to your long-term financial health.
Consider this: If you hold $100k in cash today and the inflation rate is 3% per year, in 25 years, your $100k will have the purchasing power of only about $47,761. Change the inflation rate to 5%, and your purchasing power drops to $29,530.
Said differently, let's assume a basket of goods costs $100k today; how much money would you need in 25 years to purchase this same basket of goods, assuming a 3% annual inflation rate? The answer is $209,378. 5% inflation rate? $338,635.
So, while your cash balance remains the same, its value in terms of what it can buy diminishes significantly.
Cash Isn't Keeping Up
In the short term, holding cash might make sense for emergencies or planned expenses. However, as a long-term strategy, it's akin to slowly watching your wealth fade away. The average inflation rate in the United States has been around 3% over the past century, which means that, on average, the value of cash halves roughly every 24 years.
Many people assume that their money is "safe" in cash because it's not exposed to the ups and downs of the stock market. But this perceived safety is an illusion. By not investing your money, you're effectively guaranteeing a loss in purchasing power over time. Even in periods of low inflation, this gradual erosion can have a profound impact on your financial future.
The Lost Opportunity for Growth
Another significant risk of holding too much cash is the opportunity cost of missed growth. When you keep your money in cash, you're forgoing the potential returns that could be generated by investing in stocks, bonds, real estate, or other assets. Historically, these asset classes have provided returns that far outpace inflation, helping to grow wealth over time.
For example, the average annual return of the S&P 500, a broad measure of the U.S. stock market, has been around 10% over the long term. Even after accounting for inflation, this represents a substantial real return that can significantly enhance your purchasing power. You're missing out on this compounding growth by keeping your money in cash.
Diversification: A Better Approach
So, what's the alternative? While holding some cash is important for liquidity and short-term needs, it's crucial to diversify your investments to include assets that can outpace inflation. Stocks, bonds, real estate, and other investment vehicles have historically provided returns that not only protect against inflation but also build wealth over time.
Diversification helps to spread risk across different asset classes, ensuring that you're not overly exposed to the volatility of any one investment. By balancing your portfolio between cash and other assets, you can achieve a mix of stability, liquidity, and growth potential that aligns with your financial goals.
Don't Let Inflation Erode Your Wealth
The bottom line: Many investors overlook the risk of keeping too much of their wealth in cash. Cash's stability is deceptive, as it silently erodes purchasing power over time due to inflation. To protect and compound your wealth, it's essential to diversify your investments and ensure that your portfolio includes assets that can outpace inflation. Don't let the hidden threat of inflation eat away at your hard-earned money—take a proactive approach to investing and secure your financial future.
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Matt Faubion, CFP®
Founder - Wealth Manager
This article is for informational purposes only and is not a replacement for real-life advice, so make sure to consult your tax, legal, accounting, and financial professionals if you want more information. This content is developed from sources believed to be providing accurate information, and provided by Copyright (c) 2024 Faubion Wealth Management LLC. All rights reserved. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.