The Opportunity Cost of Holding Too Much Cash

Sameer Mehta, Head of Goals-based Planning

Many clients find themselves holding onto a large sum of cash, waiting to find the right time or purpose to utilize it. Perhaps you set aside the cash for a large purchase such as a new vacation home, or you are waiting for the right opportunity to invest into the market. Whatever the reason, holding too much cash can have a significant impact on your long-term financial goals.

Cash comes at a cost

When you are holding on to more cash than you need, it comes at a cost – the opportunity cost of the potential returns you could be missing out on by not investing that cash into the market. While cash may feel safe and secure, it is important to remember that inflation can erode the purchasing power of your money over time. In other words, the longer you hold onto cash, the less it will be worth in the future.

Illustrating the real opportunity cost through a case study

It can be difficult to emotionally connect with the idea of missed investment returns. This is natural, but it is important to understand how this could impact your long-term financial goals. The concerns and emotions of the present greatly outweigh the feelings of the distant future. This is what behavioral scientists call present bias. At the same time, the principle of loss aversion tells us that potential losses are more painful, and more motivating, than potential gains. So when we are hesitant to “lose” our cash in the present, we owe it to ourselves to make the most rational, balanced decision possible by also considering exactly what we might “lose” in the future if we don’t invest.

Let’s take a look at the case study below that demonstrates how not investing your cash may lead to missed potential opportunities for growth.

The situation

Sophia recently sold a stake in her successful cosmetics business for $35MM. After having set aside $5MM towards short term commitments and a real estate investment, she approached her team at J.P. Morgan about a strategy for the rest of her portfolio. She had no other needs for liquidity or income, but felt hesitant about being fully invested in the market given the uncertainty. Sophia felt that keeping aside 30% in cash might make her more comfortable. 

Our approach

Using our goals-based planning model, her team demonstrated that if she invested in a diversified portfolio of stocks and bonds⁴, she could potentially earn an expected annual return of 6.4%⁵, which would grow her wealth to approximately $99.5MM⁶ in 20 years. However, if she were to keep aside 30% in cash⁷ while investing the rest in the same portfolio, she would only have $81MM⁸ in 20 years. Her team explained that this was a difference of what would be an additional ~ $11MM⁹ in today’s dollars – more than a third of the surplus she had today.

The Outcome

Sophia began to think of what she could achieve with that additional wealth if she had it today. 

After some deliberation and a detailed analysis, she agreed that holding 10% in cash was more appropriate and still provided her with a psychological safety net that would allow her to mind to be at ease.

She realised that by holding on to too much cash, she was essentially limiting her potential for growth and putting her long-term financial goals at risk.

Finding the Right Balance

There is no perfect answer. When it comes to creating your wealth plan, think about what is important to you and the intent of your wealth. Have an open dialogue with your family. Agree on what you would all collectively like your wealth to achieve for you as you build a goals-based plan.

Finally, it is important to regularly review your investment portfolio to ensure that it is aligned with your long-term financial goals and risk tolerance. Do not let the opportunity cost of holding too much cash impact your long-term financial goals.

To help you define your liquidity bucket and evaluate your own cash management plan, talk to your J.P. Morgan team. We can help you develop an investment strategy that is aligned with your goals and risk tolerance.

Notes:

* MAPS Analysis

IMPORTANT: The projections or other information generated by the Morgan Asset Projection System (“MAPS”) regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual or estimated investment vehicle results and are not guarantees of future results. The results may vary with each use and over time. Furthermore, the material is incomplete without reference to, and should be viewed in conjunction with, the verbal briefing provided by J.P. Morgan representative. For further information, see disclosures entitled “Understanding long-term estimates.”Illustrating the real opportunity cost through a case study.

¹ Calculations based upon assumptions listed. For allocation details, see asset allocation page. Tax rates quoted are for the majority of the years in the analysis.

² “Most probable wealth values,” denoted by the darkly shaded area, indicates the range in and around the 50th percentile. The “50th percentile” indicates the middle wealth value of the entire range of probable wealth values. The “95th percentile” wealth value indicates that 95% of the probable wealth values will be equal to or below that number; the “5th percentile” wealth value indicates that 5% of the probable wealth values will be equal to or below that number.

³ Initial allocation value adjusted for inflation rate of 2.6% per annum. Illustrates the future value that is equivalent to the initial allocation’s purchasing power.

^{For illustrative purposes only. It is not possible to invest directly in an index.}

Footnotes

⁴ Assumes an allocation 40% MSCI World and 60% Barclays global aggregate bonds, no taxes

⁵Assumes expected annual return of 6.4% and expected volatility of 7.3%, translating into a compounded return of 6.2% (Source: Long-term Capital Market Assumptions [LTCMA], J.P. Morgan Asset Management, Source Date: November 7, 2022)

⁶ Indicates median wealth outcome (50^th percentile) from the range of outcomes in year 20. The projections or other information are generated by the Morgan Asset Projection System (“MAPS”) regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual or estimated investment vehicle results and are not guarantees of future results. The results may vary with each use and over time. Furthermore, the material is incomplete without reference to, and should be viewed in conjunction with, the verbal briefing provided by J.P. Morgan representative.

⁷ Assumes an allocation 28% MSCI World, 42% Barclays global aggregate bonds, 30% cash, no taxes. Expected annual return of 5.2% and expected volatility of 5.1%, translating into a compounded return of 5.1% (Source: LTCMA, J.P. Morgan Asset Management, Source Date: November 7, 2022)

⁸ Indicates median wealth outcome (50^th percentile) from the range of outcomes in year 20.

⁹ Rate of discount used is the long-term inflation rate of 2.6% (Source: LTCMA, J.P. Morgan Asset Management, Source Date: November 7, 2022)

All case studies are shown for illustrative purposes only and should not be relied upon as advice or interpreted as a recommendation. They are based on current market conditions that constitute our judgment and are subject to change. Results shown are not meant to be representative of actual results or experience of other individuals.

Understanding Long-term Estimates (based on JP Morgan Long-Term Capital Market Assumptions)

Our investment management research incorporates our proprietary projections of the returns and volatility of each asset class over the long term, as well as estimates of the correlations among asset classes. Clearly, financial firms cannot predict how markets will perform in the future. But we do believe that by analyzing current economic and market conditions and historical market trends, and then, most critically, making projections of future economic growth, inflation, and real yields for each country, we can estimate the long-term performance for an entire asset class, given current and our estimated equilibrium levels. The “equilibrium” level shows the average or central tendency around which a market or macroeconomic variable such as yield or credit spread will tend to fluctuate over the long-term, because the level represents the value inherent in a given market. The return assumptions are based on our proprietary process of using a building block approach for each of the asset classes. For instance, the building blocks for equity consist of our projections on revenue and margin growth, dividend yield and buybacks, and change in valuations. The building blocks for fixed income consist of our projections for future yields and the change in bond prices. The estimates for alternatives are driven by our historical analysis and judgment about the relationship to public markets. It is possible – indeed, probable – that actual returns will vary considerably from this, even for a number of years. But we believe that market returns will always at some point return to the equilibrium trend. We further believe that these kinds of forward-looking assessments are far more accurate than historical trends in deciding what asset class performance will be, and how best to determine an optimal asset mix.

In reviewing this material, please understand that all references to return are not promises, or even estimates, of actual returns one may achieve. The assumptions are not based on specific products and do not reflect fees, such as investment management fees, oversight fees, transaction costs or other expenses that could reduce return. They simply show what the long-term return should be, according to our best estimates of current and equilibrium conditions. Also note that actual performance may be affected by the expertise of the person who actually manages these investments, both in picking individual securities and possibly adjusting the mix periodically to take advantage of asset class undervaluations and overvaluations caused by market trends.

For the purpose of this analysis volatility is defined as a statistical measure of the dispersion of return for a given allocation and is measured as the standard deviation of the allocation’s arithmetic return. The Sharpe ratio is a return/risk measure, where the return (the numerator) is defined as the incremental annual return of an investment over the risk free rate. Risk (the denominator) is defined as the standard deviation (volatility) of the allocation’s return less the risk free rate. The risk free rate utilized is J.P. Morgan’s long-term assumption for Cash. Correlation is a statistical measure of the degree to which the movements of two variables, in this case asset class returns, are related. Correlation can range from -1 to 1 with 1 indicating that the returns of two assets move directionally in concert with one another, i.e. they behave in the same way during the same time. A correlation of 0 indicates that the returns move independently of each other and -1 indicates that they move in the opposite direction.

INDEX DEFINITIONS

Representing Global Aggregate Bonds hed, the Bloomberg Barclays Global Aggregate Index is a flagship measure of the global investment grade dbt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers. (source: Bloomberg Finance L.P.).

Representing Developed World Equity, the MSCI World Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global developed markets (source: MSCI Barra).

Indices are not investment products and may not be considered for investment.