My dad used to keep large amounts in his checking account (no interest) and a passbook savings account (4%, if I remember). Whenever I wanted to talk about investments, he’d tell me to “go blow”, and how happy he was that his money was safe and he wasn’t losing anything.
Then he got into the hands of a charming broker, who (he pointed out) called him more often than I did. The broker recommended tons of what Dad thought were “safe” investments—can’t miss stocks and bonds, which Dad was sure were safe. Unfortunately, the stocks missed, the bonds were junk, and when I wrested control of it all in 2007, I calculated the charmer had lost him about $300,000 in junk investments and commissions from churning the account.
Dad was completely wrong in both instances.
The second is easily addressed—don’t invest in anything where you don’t understand the rationale. If someone is recommending something, understand why you should invest. And if someone is your investment advisor, at least understand what their recommendations are based on, and whether they have a plan for your entire portfolio, not just a bunch of “hot” investments. Invest in individual stocks if you want, but be okay with losing Every. Last. Cent. (I’ve had a few of those.)
If only I had a buck for everyone who told me how nice their broker was! Do you think they’d ever sell anything if they had horns and a forked tail?
But let’s look at Dad’s first principle—cash is safe. Is it?
Mom and Dad were flying high in the early 80s, when they were buying and rolling over CDs that were paying somewhere around 15%. They were living off the interest and living well—nobody had ever explained to them “safe withdrawal rates” and they spent all the interest, because after all, their principle was safe. It was only when rates began to crater that they fell into the clutches and promises of Todd, looking to replace that great, but now unobtainable return. So here was the first problem (ok boring name): reinvestment risk. We’re seeing the same thing today with CDs, which have hovered over 5% for some months now—it seems like a fortune compared to what they’ve been paying for years. But most of these high flyers are only for 6 months or 1 year. Bankers aren’t that stupid, and they don’t want to be locked into paying higher rates if and when interest rates drop. The longer the current CD term, the lower the rate.
Mom and Dad couldn’t find anything that paid 15% by the 90s. Since they’d spent all the interest, and inflation had definitely gone up in the meantime, their principal couldn’t pay for as much as it once might have.
This is why cash isn’t as safe as they (and maybe you?) believe. It’s called lost opportunity cost.
I’m going to work through some figures here to see what those CDs actually cost them. Bear with me. Let’s work with $10,000, available and invested on March 31, 1980 and kept invested until 1990 reinvesting the original $10,000 and putting whatever they made in their mattress. That’s not what they did, but let’s compare. Based on what I was able to find, they would have made 98.94% on their money, or $9,984=$19,984. This is figuring only simple interest for each year, and does not reflect the value of compounding—i.e. leaving the money invested, or reinvesting the total principle + earnings each year.
However, let’s say they’d picked a relatively benign fund, like the Vanguard Wellington, which was around back then. In simple interest terms, they would have earned 164.54% on their money, or had $26,454 in simple return ($36,454 total). No compounding—and this return would be a combination of yield and share price improvement. NB if we were to include compound returns (which I wasn’t able to calculate for the CD), the Wellington would have had a total return of 372.21%, or their $10,000 would have grown to $47,220.57 (Source: Morningstar & Forbes). Their opting for “safety” actually cost them at least $16,470. That is LOST OPPORTUNITY. *
It’s true that Wellington actually lost money in two of those years (1981-82, -1.32% and 1987-88, down 0.94%), but in every other year it exceeded returns of CDs, sometimes by 20 points or more. Granted, these were go-go years, but that was true for both investments.
The take away? If you absolutely must have your money, with no loss whatsoever, in a very short period, you probably need to suffer with cash. Having cash can tide you through some bad market years if you must meet expenses during those years from a portfolio. But if you can afford to park your money for a longer period (say, 5 years or more), you are paying an awful lot for supposed safety—the lost opportunity of far better investment returns.
*Please forgive me that these figures are somewhat imprecise depending on what date I picked and the difference between simple and compounded. But I’m certain the general principle holds.
