Covid-19 taught us the importance of savings, but holding too much cash is bad. Here’s why.

How many of your friends and family have lost their jobs due to COVID-19?

The Coronavirus has resulted in an economic downturn and severe job losses. In Singapore, the retrenchment figures are at an all time high, and 1 in 4 Singaporeans have lost their jobs. It is hence unsurprising that COVID-19 has taught us the importance of having enough cash to tide through emergencies and rainy days.

While cash provides financial liquidity and a sense of security, holding too much of it can be detrimental to your wealth. If investors do not manage how much cash is held, it becomes less of a safety net, but more of a burden.

Why is it bad to hold cash?

Cash loses value over time. Due to inflation, the cost of living rises and the value of your cash devalues steadily and surely with time. This means that you are literally losing money and diminishing your purchasing power as the days go by.

Take Singapore’s GST for example. When it was first introduced in 1994, the rate was at just 3%. It then went up to 4% in 2003, then 5% in 2004, and 7% in 2007.  While the GST rate will remain at 7% in 2021, the GST rate increase to 9% cannot be deferred indefinitely. The cost of food has also gone up over the years. In 1960, the price of a burger costs an average of SGD 0.28, but how much do they cost now? 

In addition, by holding cash instead of using it to offset loans, you may be accruing interest on your unpaid credit card bills, car loans or house installments. This increases your liabilities as well as interest expenses. Furthermore, you are also losing out on opportunities to build your investment returns by keeping excessive cash in the bank instead of purchasing investment vehicles that can help you achieve your financial goals.

Risk-averse investors should hold cash, right?

Saving up is ingrained in our culture here in Asia.

Here in Asia, the importance of saving up is well ingrained into our culture. With cash being a useful form of liquid asset, it is definitely important to keep some money in a low-risk, liquid, and interest-earning platform such as a bank savings account.

However, this healthy saving culture is not without drawbacks. Many of us believe in the myth that risk-averse investors should hold on to cash as it is the safest asset that will not fail you. As discussed above, this is not true as holding cash is one sure method to lose money, even for risk-averse investors. Instead, it may be better to channel excess funds into low-risk investment vehicles such as stable bond investments or the CPF.

While sitting on a pile of cash can result in a sense of security, particularly in an uncertain post-Coronavirus world, it actually creates a false sense of well-being. At the end of the day, these excess money may be better used to generate greater financial stability in other forms of investment instruments. Holding too much cash can result in portfolio cash drag.

What is cash drag?

Cash drag happens when you hold a portion of a portfolio in cash instead of investing that portion in the market. It is also a common source of performance drag in an investor’s portfolio.

Investors often forget that cash is an asset. Just as how stocks and funds need to be managed, so does cash. It does not grow by itself if it is not actively placed into vehicles that allow it to.

Shouldn’t investors hold cash so that they can enter the market when it crashes?

Many investors believe that they can outguess the market. Instead of tapping onto the magic of cost averaging or diversifying, they choose to hold on to a large reservoir of cash, and believe that they can leverage on market swings to buy low and sell high. However, during the market swing amidst COVID-19, how many investors actually entered at the right time? There were people who sold when they should have held, and others who held on to cash in hopes of timing their market entry to no avail.

Holding on to some cash can indeed be useful in allowing the investor to tap onto investment opportunities or for use during emergencies. However, having excessive money lying around idly erodes your wealth over time.

This is not only true for individual investors, but also for businesses. Having too much cash may hint at the company’s inability to grab opportunities in new product research and development, or business expansion plans.

How much cash should I hold then?

There is no one-size-fits-all when it comes to cash management. Every individual at various life stages with different standards of living may find comfort in holding cash for different purposes.

However, there is a general rule of thumb that emergency funds should be able to sustain your lifestyle for six months in the event that you lose your source of income. The emergency fund should also be untouched except in cases of genuine emergency such as medical urgencies caused by car accidents, unexpected job losses, and more. It should not be used for things such as wedding red packets, birthday gifts for friends, or an unnecessary laptop upgrade.

Start managing your cash today

Effective cash management is important for everyone, whether you are a young working adult, experienced professional, or retiree. Seeking the help of a financial advisor on this topic can be useful to ensure that your investment portfolio is performing at its best to better reach your life goals.