Building Wealth: The Crucial Balance Between Cash and Investing
Written by Brad Laird
The key to building long-term wealth is making your money work for you. While investing is crucial for wealth accumulation, understanding the role of cash in your financial strategy is an important step.
Essential Role of Cash
Cash serves several important purposes in your financial portfolio:
Emergency Fund: An emergency fund of 3-6 months of expenses provides a safety net for unexpected events, like medical bills, home repairs, or job loss. This ensures you won't need to sell investments during a market downturn or be forced into high-interest debt.
Everyday Expenses: Cash is necessary for daily transactions and bill payments. This buffer provides financial stability and prevents overdrafts or missed payments, while also ensuring liquidity for daily transactions.
Short-term Goals (1-2 years): For goals such as saving for a car, wedding, or school fees, cash is ideal. Since these expenses occur within a short time frame, keeping funds in cash ensures that you won’t need to risk potential losses from stock market fluctuations.
It's essential to recognise that the amount of cash you need to keep on hand is highly individual and depends on your specific cashflow requirements like monthly expenses and financial obligations. However, it's crucial to remember that holding excessive cash can hinder your wealth-building potential.
The Risk of Holding Too Much Cash
Inflation Risk: A major downside of holding too much cash is inflation, which can typically outpace savings rates and diminish your purchasing power.
Opportunity Cost: By not investing in growth assets, you miss out on potential market gains and accelerating your wealth.
Holding Cash Vs Investing
While cash is essential for short-term needs, investing is generally more rewarding for long-term goals. Shares, for instance, have significantly outperformed cash historically.
Remarkably, the S&P 500 has only experienced back-to-back negative years three times since 1950. This demonstrates the market's tendency to recover and continue growing, even after downturns.
Many years show double-digit percentage gains, with many years exceeding 10% growth. This level of return is typically unattainable with cash holdings.
Even after significant declines, such as the approximately 40% drop in the early 2000s, the market has historically rebounded and reached new highs.
Long-Term Investment Comparison: Cash vs. Shares
The 2023 Vanguard Index Chart below provides a compelling comparison of long-term returns in Australia:
Cash: 4.2% average annual return over 30 years (to June 2023)
Australian shares: 9.2% average annual return over the same period
To illustrate the impact of these returns, consider two scenarios of saving $1,000 per month over 30 years:
Savings in cash: $695,951
Investing in Australian shares: $1,697,971
The difference is staggering - nearly $1 million more by investing in shares. Keep in mind that inflation will reduce the future purchasing power of $1,697,971. For example, in 30 years, a cup of coffee might cost $25. However, despite inflation, the significant difference in value between saving in cash and investing clearly demonstrates how much more wealth investing can build over time.
The Bottom Line: Make Your Money Work for You
While cash is essential for emergencies and opportunities and short-term goals, it’s unlikely to build wealth over time. Inflation often erodes the value of cash, meaning long-term growth comes from investing in assets like shares, real estate, or businesses. Balancing between cash for immediate needs and growth assets for the future is key to financial success.
For personalised guidance on finding the right balance between cash and growth assets, please don’t hesitate to contact our team at Salt Financial Group.