My Love-Hate Relationship With Cash

Careless Beginnings

I've written previously about how I used to be careless about spending. Back in those days, it was "money in, money out" for me. I'd spend whatever allowance I received.

My mother used to nag at me about the importance of saving but I'd brush her aside. You see, I'd thought of myself as rather cautious with my spending and I'd always given myself the justification that "I'll just spend whatever little I need to and save the rest". Doesn't sound too much like a stretch, does it?

Surprise. It wasn't hard to see why I frequently wound up with the same amount of money in my bank month after month after month.

Why I Love Cash

Fast forward a few years to when I started working and earning a regular salary, my savings took a turn for the better. This wasn't because I had wisened up and started to trim my expenses - no; I merely count myself lucky that my spending did not keep up with my salary.

This way, I was able to save money monthly. I watched my bank account grow within months to hit sums I never imagined I'd save so quickly.

That's also when I started minding my budget and thinking, "I could have so much more savings if I was more honest and disciplined about how I spend my money". That's when I started thinking, "So this is what setting money aside for the future looks like.

That was a partial awakening. Cash is great. Some even say cash is king. It gives you purchasing power, investing power, holding power and generally affords you freedom to do what you want. That's when I discovered I love cash.

Why I Hate Cash

Fast forward a few years when I started understanding that there was more to personal finance than just saving (origin story here). I discovered the wonders of investing, growing your wealth to beat inflation and gaining financial independence and retiring early (as many of us here fondly know it).

I quickly deployed my cash holdings heavily into investments. I looked for any ways at all to earn a better return on my cash than the measly interest it was earning in my bank. The sum of my entire net worth was advancing in value, but there was just one element holding it back. Cash.

Compared to my investments, my cash was rotting in the bank. Taking a chill in the comfortable vault of my accounts. I was working hard at my job and my cash was resting easy in its retirement home (aka my bank).

That's how I discovered I hate cash. Would you say, cash is trash?

Cash Drag

Fast forward yet another couple of months and I learnt about Cash Drag. Simply put, cash drag is performance inefficiency in your investment portfolio due to excessive or large cash holdings.

Barring cash that is set aside for emergency funds or some specific short-term goal, cash that sits in the bank with no other purpose represents cash that could be invested.

I did have cash like that sitting in my bank. And since I considered this cash part of my investment portfolio, I realised that it was inducing drag in my portfolio and somewhat reducing my overall returns.

Let Me Illustrate

Let's say you have $100,000 to invest and you invest $10,000 while holding $90,000 in cash. If your $10,000 earns a 10% return (decent on all counts) - that works out to a $1,000 profit. That's $1,000 out of your $100,000. You just earned 1%.

If you wanted to earn $5,000 on your $100,000, only the $10,000 you invested would be working towards that goal (with $90,000 just sitting in cash on the sidelines). To gain $5,000 from that $10,000 you invested, you'd have to net a 50% return! Not easy at all.

If we had deployed 100% of our cash into investment, we can see that a $5,000 (or 5%) return would be much easier to achieve.

Some Practical Applications

How do I identify and reduce cash drag? It's simple, and here's how I do it:

1. Identify hardline cash savings that are untouchable. These would be emergency funds, short-term savings goals like a house, wedding, renovation, car, etc. These should be set aside, if not in a separate account, then at least delineated clearly in your mind (I use a spreadsheet). NB: even cash savings for short-term goals can be invested in very short-term and low-volatility instruments, depending on your risk profile.

2. Identify your monthly "operating expenditure". That's basically the amount of money you need to keep in your account to pay regular bills, spend on necessities, etc. That is untouchable too.

3. Remaining cash that doesn't fall into those categories and has no other goals should be repurposed for investment.

4. There is some consideration for the construction of a "warchest" to deploy in market corrections - I don't do this religiously (i.e., only unspent expenses go towards my "warchest") as I view it ultimately as an attempt to time the market, and also I don't have much bandwidth to monitor for the next "dip". However, as thefrugalstudent has astutely pointed out, cash that was purposed for a warchest can be assigned a lifespan - after which it should just be invested as the downside of not investing it would then outweigh the potential upside/cash drag of keeping the warchest.

Ultimately, everyone is in a different situation, so I find it helpful to appraise my own situation and make the best of it rather than compare with others.

You can hold 5% cash and I can hold 10% cash but as long as we are aware of cash drag and what it does to our investments - I think it's really up to us how much cash we want to hold.

Conclusion

I've had my reasons to love cash, I've had my reasons to hate it. Cash is great on many counts and brings many benefits. But excessive cash holdings in a portfolio induces cash drag and reduces the overall return that your portfolio could be producing.

Rather than aim for outsized returns by investing a smaller portion of my portfolio, I'll settle for moderate returns and minimise cash drag by investing most (if not all) of my available cash. Achieving outsized returns will be a bonus - but I'm not putting pressure on myself to do so.

By understanding the concept of cash drag and applying it to my investments, I'll hopefully be able to enhance the efficiency and overall return of my portfolio.

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I apologise for this long post. This topic hit close to home when I learnt about it and I felt that many would benefit from it as I have. If you found it meaningful or you think someone needs to understand this concept to enhance their investments, please share it. My hope is that personal finance becomes something straightforward and an everyday affair that we can talk about frequently and candidly.

Thank you for taking the time to read this. If you appreciated this article, you might be interested in this IG page I created to document my own journey and hopefully guide some clueless soul like me.