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The Nasty Aftereffects of Holding Too Much Cash

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In terms of safe havens to protect short-term savings, cash is king. If you're an investor, however, cash can turn into a real drag. 

That's why IFA's wealth advisors don't recommend funds in which managers like to park money in cash and similar types of savings accounts. While it's true that cash can provide temporary protection against market downturns, use of such a crutch can have significant detrimental effects on your longer-term efforts to build wealth. 

To find out just how much in opportunity costs investors might be giving up by investing through funds that pad their positions with cash, our research team has crunched performance data over the past 50 years for an all-stock and globally diversified portfolio of index funds, the IFA Index Portfolio 100. Then, differing levels of cash have been added.

Each portfolio was compared by annualized performance as well as annual standard deviation, a common measure of market risk. (All returns are calculated net of IFA's maximum 0.90% annual advisory fee.) Also included is the amount a dollar invested gained at the end of this extended period. 

The results of such hypothetical cash allocations are shown below. While standard deviation levels were lower, notice how even a seemingly minor position in cash led to a relatively oversized drop in returns. 

The IFA Index Portfolio 100, which our portfolio managers run with an aim of keeping client account assets fully invested, returned an annualized 12.37% during this period. At the same time, injecting 15% cash into this portfolio resulted in lowering such a gain to 10.74%. 

For each dollar invested in Portfolio 100, that would've translated into a return of $341.57. By contrast, adding such an amount of cash reduced those gains to $164.45 per dollar invested. In other words, you would've walked away with nearly 52% less for putting 15% of your money in what essentially amounts to non-working investment capital. 

Even in smaller amounts, cash can prove costly. For example, a 10% position would've dropped your total to $190.46 per every dollar invested. That's about 44% less than sticking with Portfolio 100. The cash drag in this case at 5% wasn't as harmful, but it still amounted to more than 21% less. 

Portfolio managers at our favored fund family, Dimensional Fund Advisors, don't rely on holding any significant amounts of cash as part of their equity and fixed-income strategies. In fact, the passively managed IFA Index Portfolio 100 had some 1.5% in cash at the end of the most recent quarter, according to Morningstar data.

Instead of turning to cash to lower overall portfolio volatility, our advisors work with investors on how to parse their allocations between stock and bond funds. Unlike cash, bond funds offer opportunities to generate total returns (price appreciation plus coupon rates) that can be used to protect an investment portfolio from the long-term ravages of inflation

Along these lines, we've developed a Risk Capacity Survey. This online survey asks several key questions related to investing in order to help an investor learn which IFA Index Portfolio captures the right mix of stocks and bonds that is most appropriate for his or her unique financial situation. 

This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful.  Investing involves risks, including possible loss of principal. Performance may contain both live and back-tested data. Data is provided for illustrative purposes only, it does not represent actual performance of any client portfolio or account and it should not be interpreted as an indication of such performance. IFA Index Portfolios are recommended based on time horizon and risk tolerance. Take the IFA Risk Capacity Survey (www.ifa.com/survey) to determine which portfolio captures the right mix of stock and bond funds best suited to you.  For more information about Index Fund Advisors, Inc, please review our brochure at https://www.adviserinfo.sec.gov/ or visit www.ifa.com.