Cash might be synonymous with wealth, but investing in cash for the long-term is one of the worst investments you could make — especially if you’re in your 30s. As one well-known Warren Buffett quote states:
“Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value.” — Warren Buffett for The New York Times, 2008.
When you’re in your 30s, you have the greatest ticket to building wealth: time. The more time you have before you need to tap into your investments, the more time your money has to grow and compound. Find out how a smaller investment in stocks and bonds handily beats a much greater cash investment.
Why Cash Is the Worst Investment
Cash in and of itself isn’t inherently bad; it’s just a bad place to hold a large percentage of your long-term savings when you’re in your 30s. Because of inflation, the purchasing power of cash fades away over time. And, cash has the lowest return of all financial assets.
In the following chart, notice the historical annual returns for three-month Treasury Bills (a proxy for cash). When compared with the S&P 500 stock market returns, the returns of cash are paltry. For example, the average annualized return on cash from 1928-2014 was 3.49 percent — as represented by the three-month T.Bill — and the return on the stock market was 9.60 percent.
|YEAR||Average Inflation Rate||3-Month T.Bill (percentage %)||S&P 500 (percentage %)|
The average inflation rate between 1928 and 2014 was 3.07 percent per year, according to in2013dollars.com. Subtract the average inflation rate from the average annualized cash return, and cash grows approximately 0.42 percent per year on average.
So if you were thinking that nice stash in the bank will serve you in retirement, think again. Placing too much of your retirement cash in certificates of deposit (CDs) or your savings account when you’re in your 30s means you’ll have a tough time hitting your retirement goals.
If Not Cash, Then What?
Are you afraid of investing in the stock market? Are you worried about the recent volatility in the markets and losing all your money? Well, according to Buffett, there will always be some type of turmoil.
“Over the long term, the stock market news will be good,” wrote Buffett in the New York Times article. “In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a fly epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.”
Right now, we have international turmoil in the Middle East, Greece and China. As recently as 2008-2009, we had a housing bust, mortgage meltdown and a recession in the U.S., after which the S&P 500 more than doubled.
Buffett, one of the greatest investors, recommends investing in the stock market. His advice is based upon the growth of the U.S. (and global) markets. If you believe that U.S. and international companies will continue to grow and advance in the future, then buying shares of the stock market allows you to participate in that growth.
Harness the Power of Compounding for Wealth
With the advantage of time, a 30-something can build significant wealth — but not with cash. If you’re in your 30s, investing in stocks and bonds can grow thousands of dollars into hundreds of thousands. Consider the following example:
June invests $5,000 per year from age 30 to age 40 for a total of $50,000. Assume that her investment in stock and bond funds earns a 7 percent average annual return. During these first 10 years, her total balance reaches $69,082.
Then, June invests her $69,082 and continues to get an annual return of 7 percent. But this time, she doesn’t contribute any money. By age 65, June’s investment is now worth nearly $375,000.
Now let’s look at Jason, who waited until age 40 to begin investing. Like June, he invested $5,000 per year with a 7 percent annual return. Jason invested for 25 years until age 65 and then stopped. Jason’s $125,000 investment grew to $316,245.
June started earlier, invested $75,000 less than Jason, and at retirement had almost $60,000 more than Jason.
That is the power of starting to invest in your 30s. Buffett’s quote implies that there’s a better investment than cash: investing in the financial markets.
How Much Cash Should You Hold?
In spite of labeling cash as the worst investment in your 30s, you do need access to a certain amount of it.
Alan Moore, co-founder of the XY Planning Network — a leading organization of fee-only financial advisors that assist people with their investments — said, “There have been several studies showing that millennials are holding a lot of their investments in cash, and the knee jerk response from the advisory community and media has been to tell these young consumers to invest in the market.”
He believes, however, that holding cash is a “good thing.” “What these studies overlook is the behavioral side of financial planning,” said Moore. “What happens when you have all of your money in one basket, the market drops and you sell everything? You’re suddenly in a much worse position than if you’d remained in 100 percent cash.”
From a home down payment to putting your kids through college, you’ll need cash for a number of reasons. Get a clear picture of what’s coming in the next five to 10 years of your life, and plan your finances accordingly. “This is where financial planning is more art than science, because it takes a lot of preparation and expertise to determine appropriate levels of cash,” said Moore. “That being said, I’d rather have a little more cash than I need than not enough, so err on the side of caution.”
So, how much cash should you have in your 30s? A rule of thumb is to avoid investing any money you’ll need within the next five to seven years in the stock market. Investment markets are volatile, and you don’t want to be forced to sell after a 10 percent market correction to pay Junior’s college tuition.
Many experts also recommend keeping six to nine months of your salary in cash. But realistically, the exact amount of cash to hold is personal and depends on expected future expenses.
Keep reading: The Worst Investment to Make in Your 40s
Be wise, heed Warren Buffett’s quotes, and recognize that the best investments for building long-term wealth are diversified stock and bond funds. Don’t hold any more cash than you need for the short-to-intermediate term.