How can cash cost you cash?

Well there is a little something called inflation

Inflation

Definition: Inflation is the rate at which the general level of prices for goods and services in an economy rises, leading to a decrease in purchasing power. In other words, as inflation increases, each currency unit buys fewer goods and services.

  • Inflation means that the cash you have today loses its value over time. As prices for goods and services increase, the same amount of money will buy you less than it did before. This reduces the purchasing power of your money, making it worth less in the future compared to now.

Why do we even have inflation

Inflation occurs for a few reasons, primarily when demand for goods and services exceeds supply (demand-pull inflation), or when production costs rise, causing companies to raise prices (cost-push inflation). Central banks may also influence inflation by adjusting interest rates or money supply to manage economic growth.

A moderate level of inflation is beneficial because it encourages spending and investment. If prices are expected to rise, people are more likely to spend or invest their money rather than hoard it, which stimulates economic activity. Inflation also helps reduce the burden of debt over time, as borrowers repay loans with money that is slightly less valuable than when they borrowed it.

Effects on your portfolio

  • Since we know moderate inflation benefits the economy, it's also good for your assets, like real estate, stocks, or businesses. As inflation causes prices to rise over time, the value of these assets tends to increase as well. For example, a house you own or shares in a company may become worth more because they can command higher prices in an inflationary environment.

  • Another effect of inflation is that holding too much cash in your portfolio becomes costly, not just because inflation erodes its value, but also because of the opportunity cost. Cash doesn't generate returns like investments in stocks, bonds, or real estate. So, by holding large amounts of cash, you're missing out on potential gains that other assets can provide, especially as they tend to increase in value over time, outpacing inflation. Essentially, holding too much cash means losing both purchasing power and growth opportunities.

Cash Opportunity & Inflation Cost Calculator





Results (Over 20 Years):

Cash percentage

The challenge with cash is finding the right balance. While too much cash can lead to opportunity loss and erosion by inflation, having some cash is essential because it's risk-free and liquid.

Cash can be useful during market downturns, allowing you to buy stocks or assets at lower prices when others are selling in panic, potentially leading to great returns when markets recover.

So how much cash should you keep?

The amount of cash you should keep on hand depends on your personal situation and the risk-reward balance you're comfortable with. Cash is safe and stable, but it doesn't generate returns, meaning you miss out on potential growth opportunities. On the other hand, holding more investments like stocks can provide higher returns, but they come with more risk, especially during market volatility.

Cash %

The risk-reward ratio can be visualized as a curve: on one side, as you increase your investments and reduce cash, your potential returns grow, but so does your exposure to risk. On the other side, as you hold more cash, your risk decreases, but so do your potential gains.

The key takeaway is that when you start holding more than about 15% of your portfolio in cash, the drop in gains becomes more noticeable. This is because inflation starts to hit you harder, eroding the purchasing power of your cash. At this point, the money you're not investing begins to lose value faster, while your returns from safer assets like cash fall behind what you could have earned by investing more in assets that grow with inflation, like stocks or real estate.