Believe it or not, there is such a thing as having too much cash.
Aside from having some cash on hand to handle recurring transactions and short-term spending, holding excess cash as part of a long-term investing strategy can actually be wasteful.
In a research paper published in Financial Analysts Journal last year, Vanguard founder John Bogle cited cash drag as one of the ways investors are not making the most of their investments.1
Smart investors strive for the best after-tax returns given the level of risk appropriate for their goals. This means controlling costs, investing tax-efficiently, and making sure your portfolio maintains the right level of risk for your goals.
Cash is not part of a good long-term portfolio allocation because it can reduce overall returns—yet it ends up in many portfolios.
According to Betterment research, the average non-Betterment account has $31,000 in idle cash—meaning $200,000 in lost returns over 30 years at a 7% growth rate.2 By comparison, the average 20-year return for the S&P 500 index is 10%.
We define cash as currency or cash-equivalent securities, such as money market funds. Cash is “idle” when it exists in an investment account (non-checking or savings accounts), because it’s not working for you. Some refer to this as “cash drag” because it is likely dragging down your potential returns.
After taxes and inflation, currently cash has a near-zero, even slightly negative, expected return.
How Does Cash Turn Up in a Portfolio?
Cash in an investment portfolio can come from multiple sources. First, the mutual funds and exchange-traded funds (ETFs) you hold may contain cash because the fund’s manager needs to be ready to meet fund redemptions. (Note that Betterment portfolios never have idle cash. We explain why below.)
Across the universe of non-Betterment U.S. equity mutual funds, Morningstar Inc. calculated an average cash weighting of 3.2%. Index-tracking funds, especially ETFs such as those Betterment uses in our portfolio, tend to carry a much lower cash allocation than active funds.
Cash can also build up if dividend payouts from investments aren’t automatically reinvested.
Furthermore, if your brokerage doesn’t offer fractional shares, you might have insufficient cash to purchase full shares. Betterment offers fractional shares to put every penny in your investment account to work.
How Much Cash Is Too Much?
While a small portion of cash may seem insignificant, it can still significantly drag down your returns due to compounding.
If your cost to re-invest cash into securities outweighs the value of the trade by some threshold, you should hold the cash until you have more to invest. If trading is free, and you can buy any fractional increment of shares, you should hold no cash.
If we assume an average trading cost of $7 per trade (typical of discount brokerages) and you don’t want to reduce your returns by more than 1%, then you should have, at most, $700 of cash. Even though we recommend having no cash at all because any amount may reduce your returns, for practical reasons we believe portfolios have too much cash when they exceed $700 in cash.
Betterment Exposes Opportunities to Invest Idle Cash
Being an empowered investor is all about knowing where you stand. If you don’t know you have idle cash in your portfolio, you can’t do do anything about it.
Your Betterment portfolios never have idle cash, because we use fractional shares and available cash is invested as soon as possible.
You may, however, be reducing your own returns on your outside, non-Betterment accounts, and not know it. Using Betterment’s account syncing features, customers can see from the Portfolio tab where they have cash allocations for all of their outside investments.
In addition to the overall cash, which includes cash inside your funds, we highlight each portfolio’s total idle cash, along with a simple projection of how much potential returns could be lost by holding that cash amount long-term.
By syncing your outside investment accounts with Betterment, we’ll also monitor your portfolio and let you know at login if you have any idle cash (along with any high fees). Securely syncing your outside investment and debt accounts, such as 401(k)s, IRAs, taxable accounts, mortgages, and loans held at other institutions, helps put you in control of your wealth, and also helps us give you better advice with retirement tools like RetireGuide.
Your synced account data is updated automatically, every day, so you’ll always have the most current balances in the funds in which you’re invested, and more importantly, you’ll always know where you stand across investments and available cash holdings. Get started syncing all of your outside investment accounts with Betterment today.
1The Arithmetic of “All-In” Investment Expenses, by John Bogle.
2Average cash balance based on Betterment’s analysis of approximately 29,500 non-Betterment accounts synced by over 12,600 customers. Assumes 0.15% Betterment fee and ETF expenses of 0.12%, typical of a Betterment customer, with 0% return on cash. We’ve updated our pricing structure since this article was published. Learn more at betterment.com/pricing.
More From Betterment: