Goals-Based Planning
The cost of too much cash
Powerful forces—loss aversion, a need for control—may lead to irrational decisions about cash holdings. Here’s how to think clearly about cash.
We have too much of your cash.
It’s an unusual admission for a financial institution, but it’s true. Holding on to cash, even when we know it could be put to better use, is a common and understandable decision. But it’s an irrational one.
As head of Behavioral Science at J.P. Morgan, my job is to understand why we make such irrational decisions and consider how we can reframe our decision making to reach better outcomes. In that spirit, let’s look at some of the reasons so many of us hold on to too much cash.
Loss aversion
Loss aversion—in which we are more motivated to avoid loss than to pursue gain—is one of the most powerful forces in behavioral finance. The pain of losing $10 is only matched by the pleasure of winning $20.
We express loss aversion when we say things like “I don’t want to risk all my money” or “I’m worried the market is peaking and I’ll be wiped out.” We keep our cash out of investments because we’re afraid of losing it.
But when we sit on our cash, we really stand to lose something else: Our purchasing power.
Exhibit 1: Holding cash is expected to erode purchasing power over the next few years
A bar chart shows the expected change in purchasing power of 100 units of cash in dollars, starting in 2021 through 2024. By 2024, the purchasing power of the original 100 units of cash is projected to decline to 98.6 dollars.
The balances in our accounts may stay the same, but the power of that money shrinks as the economy grows and prices rise.
We also lose ground in the pursuit of our long-term goals. Idle cash can create a massive “return drag” on an investment strategy. And much like investing provides compound interest, not investing can cause compound losses.
If we’ve developed a plan to help reach particular goals—paying for a child’s wedding, a family safari, home renovations, retirement—not using all of our resources to pursue those goals creates the potential for loss. Those losses aren’t just numbers, they’re flower arrangements at the reception, an extra weekend in Africa or a pool for the grandkids. They’re the details of our dreams.
Of course we do want to keep some cash on hand, both to cover spending for a year or so and also to provide a psychological safety net. In our goals-based planning framework, liquidity/cash is one of several “buckets” in an overall wealth strategy (see Make a plan that even “future you” will love).
For many of us, an ample cash balance helps us feel more comfortable taking risk in the rest of our portfolio. Today, one perceived risk is that we might be investing cash at a high point of the market. Well, we know we can’t time the market, so we can’t promise we’re not at a peak. But we can remind ourselves that even if we do invest at the peak of the market, we are still likely to prosper in the long run (Exhibit 2).
Exhibit 2: What would have happened if you invested at the worst time in each calendar year?
A line chart shows returns after investing at intra-year market highs from 1989 through 2021. The S&P 500 has risen over time. The graphic also presents a table showing that an investor who put money to work at intra-year peaks in the equity market generated a 7.5% annualized return over a 5-year time horizon from a balanced allocation (which assumes a 55% allocation to the S&P 500 and a 45% allocation to the Bloomberg Barclays U.S. Aggregate index, rebalanced quarterly), versus a 2.7% annualized return over a 5-year time horizon from an investment in cash. To note, when investing at intra-year highs, the balanced allocation has generated positive returns during each subsequent five-year period since 1989 (that’s to say, never has the annualized return been negative over that time horizon).
Present bias
What do we do when we feel seasick? We shift our gaze from the waves shaking the hull out to the calm stability of the distant horizon. The same principle applies when navigating rough financial waters.
Present bias is the principle that explains why, for many of us, now matters more than later.
The emotions of the present greatly outweigh the potential benefits of the future. In fact, we consider our future selves to be completely different people. While doing something right now feels good, doing something for our future elicits close to no emotional response. That’s why it’s so hard to do things today—whether it’s exercise, eating healthy or letting go of our cash—that will benefit our tomorrow. We connect to our cash now more than our investment outcomes later—it just feels better.
So, what can we do?
Instead of thinking about the next six months or year, we can think about the next six years or decade. Remember, we’re not investing for ourselves today, but for our future selves and our families many years from now.
Research shows that when we make that future more personal, visible and detailed, we can see it more clearly and feel it more viscerally. It helps to be specific: We’re not just “retiring in about 20 years” but “retiring on April 30, 2041.” Visualize the details of trips, second homes or special events. What’s the weather like, where are we and with whom? Let’s look at our elders and imagine how we might appear in 20, 30 years. What do we sound like, what do we feel like, how happy are we that we’ve achieved our goals?
We also might overcome present bias by taking solace knowing that, historically, sticking with a long-term investment vision has provided less volatile and more stable returns.
Exhibit 3: Maintain a long-run mindset: Time and diversification can help reduce uncertainty for long-term investors
A bar chart shows the range of rolling annualized total returns for stocks, bonds and a 50/50 blend between 1950 and 2020. Bars show returns for one, five, 10, and 20 year rolling periods. Over a 20-year period, stocks’ average annualized total return range was 5% to 18%; bonds’ average annualized total return range was 2% to 11%; and a 50/50 blend of stocks and bonds’ average annualized total return range was 5% and 14%.
Need for control
“Keeping a lot of cash allows me the flexibility to change my mind and be opportunistic.” We’ve all said something like that. When we talk about “flexibility” and “being opportunistic,” we’re really talking about our desire for control.
The need for control is a basic motivator of human behavior. And because cash is the most tangible, fungible, accessible and emotionally connected form of money, holding on to it offers us the feeling of control.
But when we fail to maximize our financial resources, we’re actually giving up control. We’re sitting back, waiting for some unforeseen event or person to dictate our options.
Using our money wisely is the best way to control our financial future. That’s why we build financial plans and wealth strategies in the first place. Harnessing the potential of our cash is a smart way to support these plans and strategies. It makes our money work for us, in a framework that takes into account our risks, opportunities, needs and desires. There are even solutions that provide the immediate flexibility of cash if that’s part of the plan.
“Cash is safe”
We’ve all heard the message that cash is “safe” in the face of market volatility, political turbulence or social unrest.
Cash feels safe because the number stays the same. But that number doesn’t represent the power of money that—in cash—is shrinking every day. It’s what we can do with money that matters, and what we can do is not always safe.
And while cash can “protect us on the downside” more than some investments, government bonds and certain municipal bonds have retained more value during market dips than cash, while also providing some growth during other market conditions.
Exhibit 4: Some examples of reasons not to invest
A table shows a year-by-year breakdown of reasons people may have been afraid to invest from 1999 to the present, along with the cumulative price returns that would have been generated had an investor put money to work in a given year and stayed invested through the present. For example, in 1999, Y2K was an oft-cited concern for investors. Since 1999, however, the S&P 500 has generated a cumulative price return of 246.8%. As a more recent example, 2020’s COVID-19 pandemic and the U.S. presidential election were among the top worries, but the S&P 500 has returned 31.9% since.
Of course, there are no guarantees in investing, but history reminds us how good even the bad times can be in the long run. Look how much the stock market has climbed after each of the “worst-case scenarios” in the last two decades (Exhibit 4). The COVID-19 market plunge and rapid rebound is a recent case in point.
The big picture for your wealth strategy
No one ever lay on her deathbed wishing she had spent more time with her money.
We don’t really want money. We want what money can provide: Security, autonomy, control, power, respect, freedom, a sense of pride and achievement. These personal goals can be hard to quantify and articulate. Since money is easy to quantify, it often becomes a substitute for what we really want.
What is the purpose of your wealth? What do you want your money to do for you? It can be hard to think about. But that’s a key reason we developed a goals-based framework, understanding that liquidity and cash are just one part of our plan, one bucket in our wealth strategy.
Holding excessively large cash deposits is an understandable choice, but an irrational one. When we comprehend why we make that choice, we might be able to reframe our decision-making process to keep us moving along our own personal journey to a richer and more meaningful life.
Reach out to your J.P. Morgan team to learn more about a goals-based approach to managing cash.
