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Actually, holding cash can be very risky. Let me tell you why.
I met with a prospective client who was recently widowed. She told me the stock market terrified her and she wanted to keep everything in cash. Her assets were in a six-month certificate of deposit earning a paltry interest of 0.79 percent.
While there is much discussion about deflation, the inflation rate for 2009 averaged 3.85 percent, which is consistent with the long-term average inflation rate of 3.42 percent. The current inflation rate is 1.05 percent.
When the return on your cash is less than the rate of inflation, you are guaranteeing a loss of purchasing power. Here’s an example:
When inflation is running at 3 percent, the value of $100 will drop to $76 in just ten years. Over two decades, the value of that $100 is worth only $56.
An investment strategy that ensures this kind of a loss is very risky.
I am not suggesting that you keep no cash available. Many financial planners recommend having up to two years of living expenses in cash. The cash should be kept in a short-term FDIC-insured savings account, certificates of deposit, Treasury bills, or a money market account with a major fund family, like Vanguard, Fidelity, or Charles Schwab.
In selecting a money market fund, focus on low expenses. The Vanguard Prime Money Market Fund (VMMXX) has an expense ratio of only 0.25 percent. Comparable funds have expense ratios as high as 1 percent. Just say no to them!
When checking bank rates, be sure to look online. The great equalizer is whether your account is FDIC insured. (You can verify whether a bank is FDIC insured by going to the website of the FDIC.) If it is, go for the bank with the highest interest rate.
Once your emergency fund is properly secured, excess cash should be used to eliminate credit card debt. Next, eliminate other consumer debt (like your car loan). If you have a student loan, pay it off or reduce the balance.
If you have dependents, check your insurance. What would they do if something happened to you? Consider purchasing low-cost term insurance on your life. Check out disability insurance. It is often overlooked in financial planning, yet you are three and a half times more likely to be injured during your years of working and raising dependents (and therefore to need disability insurance) than you are to die (and need life insurance).
With these pieces of the financial puzzle in place, you are now ready to consider investing. Some exposure to the stock market—as scary as it may seem—is essential if you want to outpace inflation. Here’s a simple investment strategy:
1. Determine your asset allocation (the division of your portfolio between stocks and bonds). You can do this by taking a short asset allocation questionnaire.
2. Buy three low-cost index funds. Vanguard, Fidelity Investments, T. Rowe Price, and other major fund families offer low-cost index funds that will allow you to diversify your risk without spending a lot of money. Here are three good examples from Vanguard:
3. Rebalance your portfolio once or twice a year to keep your asset allocation intact or if your investment objectives or tolerance for risk has changed. Long-term annualized returns from these portfolios range from 8 percent to almost 10 percent—well above the rate of inflation.
Dan Solin is a Senior Vice-President of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You’ll Ever Read, The Smartest 401(k) Book You’ll Ever Read, and The Smartest Retirement Book You’ll Ever Read. . His latest book is Timeless Investment Advice.
Watch Dan on YouTube.
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