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Investing Basics

The Real Cost of Cash Drag

A broker that’s selling you cash as an investment should make you think twice, especially when it’s not in your best interest—but it is in theirs.

Articles by Dan Egan

By Dan Egan
Managing Director of Behavioral Finance & Investing, Betterment  |  Published: March 11, 2015

Cash has a significant chance of a negative real return over time due to inflation risk.

You never hold cash at Betterment, as we use fractional shares. That ensures every dollar—down to the penny—is fully invested in a diversified portfolio of stocks and bonds.

Cash has a significant chance of a real negative return over time due to inflation risk.

Cash assets can present a conflict of interest when the investment manager is advising cash and then re-investing it for its own revenue. At Betterment, we offer Smart Saver as a solution for unused cash, that you hold as a buffer or haven’t yet put to use, butother than that, we do not recommend usingcash or cash equivalents as a primary part of your financial planning strategy.

For the goals you set at Betterment, you never hold cash because we use fractional shares to invest every cent you deposit. Every dollar—down to the penny—is fully invested in a diversified portfolio of stocks and bonds.

It’s pretty plain and simple: Cash is not a good investment for the long term. After taxes, inflation, and its current expected return (zero), you are actually losing money when you hold cash in your investment portfolio over the long term. In other words, cash is a drag on your returns. If you must hold excess cash, you should do so in a vehicle that helps to mitigate the effects of inflation and is tax-efficient.

We are hardly the only investment manager to take this stance. 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

Cash Costs You Returns

Certain investment services require you to hold cash in your account. In practice, your cash holdings could range from a tiny fraction of your balance to a substantive allocation in your portfolio.

Across the universe of U.S. equity mutual funds, Morningstar Inc. calculated an average cash weighting of 3.2%.² As Bogle noted in his paper, index-tracking funds tend to carry a lower cash load than active funds.

One recent example is with Schwab’s new automated portfolio, one of the latest imitators of Betterment’s automated investing technology. Its new offering requires a cash position from a minimum of 6% to as much as 30% cash, according to Schwab’s disclosures.³

Then there are other automated services and traditional managers that force you to keep a small amount of cash on the side because they aren’t able to do fractional share trading.

We’re not fans of either scenario, but the first one is especially troublesome. For the smart investor, there are several red flags here.

Cost No. 1: You’re not earning returns, and are losing money.

First, the most obvious issue is that cash is simply not a risk-free investment and doesn’t belong in any moderate to long-term investment portfolio. It currently returns almost zero and when you factor in inflation, can lose you money. That means the more cash in your portfolio, and the longer you invest, the less your portfolio may be worth compared to a portfolio without cash. Be wary of any advisor who talks about cash without adjusting for inflation.

While a small portion of cash, for example an allocation of 6%, may seem like an insignificant amount, it still can have a significant drag on returns. This is especially true for a long-term investor who should be in a high-stock allocation.

For illustrative purposes, let’s have a look at Schwab’s recommendation for “Investor 2,” a 40-year-old with moderate risk tolerance. The portfolio is 61% stocks, but you’re forced hold 10.5% cash.4 A Betterment portfolio at 61% stocks, with no cash drag, has an expected annual return of 5.8%. Let’s generously assume that cash returns 1% annually (currently, it’s much less than that). With 10.5% of your assets on the sidelines, the effective cost would be 0.5% in lower expected returns every year.

The Cost of “Cash Drag” on a $100,000 Investment

Over the next 30 years, having 10.5% cash in your portfolio will cost you $73,417 compared to the same portfolio with zero cash drag

Cost No. 2: It’s a conflict of interest.

A small amount of cash in your portfolio resulting from an inefficient trading structure is one thing. But an entire asset dedicated to cash holding should raise eyebrows. This is particularly important when it comes to a portfolio that is billed as “free.”

For example, Schwab is marketing its new portfolio as “free,” yet there exists a very real underlying cost hidden in the allocation structure. You, the individual investor, are paying a hidden fee via the cash allocation you are forced to hold. (We’re not the only ones to point this out.) How does that work?

In Schwab’s fine print, Schwab is explicit that it will use your cash, held in its company’s bank, for its own investing, providing them with revenue and reducing your expected returns.5

Herein lies the conflict of interest: As a customer, you now have a portfolio manager who is incentivized to have you hold more cash than might be optimal for your investment strategy—simply because they make money on it. Schwab even acknowledges this conflict of interest in its recent filing with the U.S. Securities and Exchange Commission (SEC), specifically calling out that not even other Schwab entities would allocate so much of a portfolio to cash:

In most of the investment strategies, the percentage of the Sweep Allocation is higher than the cash allocation would be in a similar strategy in a managed account program sponsored by a Schwab entity or third parties. This is because, as described below under “Fees,” clients do not pay a Program fee. (page 3)5

This conflict can have some unexpected consequences. For instance: such an allocation to cash might feel intuitively sensible because of a mental association with a “rainy day” fund. We’ve written before about how you can do better. However, let’s assume you do want a cash safety net.

With an automated, enforced cash allocation such as Schwab’s, you will never be able to withdraw just the cash if a rainy day does come. Since the cash allocation is the backdoor method by which Schwab gets paid, the service would rebalance you back into the target cash allocation, selling securities in the process, and possibly triggering capital gains. From the same filing:

[Schwab] may terminate a client from the Program for withdrawing cash from their account that brings their account balance below the minimum… (page 4)6

If you want some cash on the side, this is not it: you’ll need another cash stash in your bank account, both costing you returns over the long term.

Cost No. 3: You can better manage risk with bonds.

“But cash is safe,”’ I hear you say. “It helps stabilize the portfolio.”

“Actually so do bonds,” I say. “And they don’t reduce your expected returns like cash does.”

The vast majority of the time, you’ll be better off using bonds rather than cash. You can achieve both the lower drawdown risk while protecting against inflation risk with high-quality inflation-protected bond funds, such as Vanguard Short-Term Inflation-Protected Securities (VTIP).

The chart below depicts the rolling two-year real returns of a basket of five-year Treasury bonds versus a cash savings account.

When assessed properly (at a portfolio level), Treasury bonds have dominated cash for any non-immediate time horizon. Even through the 2008 financial crisis, you would have been better off investing in Treasury bonds than cash. Critically, bonds tend to rally when stocks are crashing, a process called the “flight to quality.”

Moreover, it’s not just the frequency with which bonds win, but also the extent of the advantage. Let’s look at the cumulative performance of a portfolio of stocks and Treasury bonds versus a portfolio of stocks and cash savings since 1955. It turns out that investing in a $100,000 portfolio of stocks and Treasury bonds in 1955 would have outperformed the same stock portfolio with cash by $44,013.

Cash Drag Reduces Portfolio Returns

Bonds beat cash by $44,013 on $100,000 initial investment

Cost No. 4: It’s not efficient.

Lastly, let’s talk about efficiency. As you may know, trading on an exchange only happens in round, whole share amounts. The result is a little bit of cash permanently left on the side. This is not an efficient way to do things.

Imagine that you have a portfolio with 12 ETFs, and one share of each ETF costs $100. Now, you make a $90 deposit (or your ETFs pay a total of $90 of dividends). With a platform that only uses whole shares, you cannot use any of that cash—read: zero dollars—to add to your investments because it’s not enough to buy a single share of anything. So that 90 bucks will just remain uninvested, waiting for additional cash, before you can buy even a single share.

As deposits and dividends flow through this account over time, it will always have some amount of pesky cash remainder sitting there. This is sub-optimal investing. At Betterment we use fractional shares, which means you invest down to the penny.

In the end, it’s important to understand the role investing has in your financial plan—and the role cash plays. When you pay for investments, whether that’s through an expense ratio or a management fee, you’re paying for the potential to earn returns, not to lose money with cash.

If you’re comfortable keeping cash on the side, remember, you can always use a savings account or a vehicle like Smart Saver.

The results above are hypothetical and for illustrative purposes only. Investing in securities always involves risks, and there is always the potential of losing money when you invest in securities: even Treasury bonds. Past performance does not guarantee future results, and the likelihood of investment outcomes are hypothetical in nature. Before investing, consider your investment objectives and Betterment’s charges and expenses.

¹http://johncbogle.com/wordpress/wp-content/uploads/2010/04/FAJ-All-In-Investment-Expenses-Jan-Feb-2014.pdf

²http://www.investmentnews.com/article/20150206/FREE/150209947/low-mutual-fund-cash-levels-not-telling-the-whole-story

³http://www.adviserinfo.sec.gov/Iapd/Content/Common/crd_iapd_Brochure.aspx?BRCHR_VRSN_ID=277224 (page 2); https://intelligent.schwab.com/public/intelligent/insights/whitepapers/role-of-cash-in-asset-allocation.html

4 Under “Can you give me an example of what these asset allocations look like?” https://intelligent.schwab.com/public/intelligent/about-intelligent-portfolios 

5 “Schwab Bank earns revenue based on the interest we receive by investing the cash, minus the interest paid on the deposit and the cost of FDIC insurance (which Schwab pays).” https://intelligent.schwab.com/about-sip.html

6 Schwab goes into more detail in its disclosure brochures: “Schwab Bank earns income on the Sweep [i.e., cash] Allocation for each investment strategy. The higher the Sweep Allocation and the lower the interest rate paid the more Schwab Bank earns, thereby creating a potential conflict of interest. The cash allocation can affect both the risk profile and performance of a portfolio.”

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