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How to Build Wealth: Don't Hold on to Too Much Cash

Millennials often keep too much of their wealth in cash instead of investing in the markets.

how to build wealth
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How to Build Wealth: Don't Hold on to Too Much Cash

Millennials often keep too much of their wealth in cash instead of investing in the markets.

Millennials, in general, are avoiding the financial markets and instead keeping more of their money in bank accounts despite historically low interest rates. Just 26 percent of people under 30 invest in stocks, according to a 2015 survey by Bankrate.com.

Three key reasons can be attributed to the shift in generational behavior:

  1. Distrust: Many millennials have experienced two recessions during their professional lives: the bursting of the dot-com bubble and the financial crisis of 2008.
  2. Flexibility: Millennials tend to value the flexibility that’s made possible by having a large amount of cash at hand.
  3. Lack of experience with inflation: Millennials have come of age in an era marked by very low inflation (an almost invisible 2.37 percent annually over the last 15 years). So they have less understanding than older generations that cash loses value over time as prices rise.

While this shift in behavior is understandable, it leads to a deeply flawed approach to wealth building. Financial advisors are concerned that millennials might be jeopardizing their futures by limiting their exposure to market returns.

"It’s very unsettling," says Deiken Maloney, director of Goals Driven Investing at Northern Trust, and a borderline millennial himself. "Holding too much cash is really a double hit to the purchasing power of your savings. You're not only giving up on the opportunity for positive real returns over time, but the purchasing power of your cash holdings — yielding basically zero — are eroding at the rate of inflation each year as well.”"Holding too much cash is really a double hit to the purchasing power of your savings."

He believes investors who hold high levels of cash realize they are giving up potential market returns, but they are likely underestimating the impact of inflation on their savings due to the extended period of benign inflation. "Iinflation really adds up, especially when the loss of purchasing power is compounded each year," he adds.

Millennials aren't blowing through their paychecks though. As a group, they're actually above-average savers, Maloney says. But they're more likely to park their savings in a checking account than put it to work in an investment account.

Maloney recommends taking a goals-driven approach to investing: establishing short-, medium- and long-term targets while putting their money to work accordingly. By considering retirement-age objectives alongside near-term priorities, millennials can craft an investment strategy that will prepare them for each life stage.

The Long View of Investing

Millennials may be more likely to take a dim view of higher-risk stock-market investments based on recent performance. But Maloney cautions that these investments aren't designed for short-term payoffs. They're meant to deliver a high-value return over a long period of market exposure.

Even over the last 15 years, the Standard & Poor's 500 index has returned about 4.2 percent annually on average, below its historical performance but better than no exposure at all and outpacing inflation. Millennials may suffer in retirement because of the market's poor recent performance, but they may suffer far more if they stay away from the stock market altogether.

"Assets earmarked for spending well into the future can withstand near-term volatility in the pursuit of long-term growth," Maloney says. Fifteen years of subpar performance might be daunting, but long-range planning for millennials covers more than half a century.

A Moderately Aggressive Short-Term Investing Approach

The stock market makes less sense for shorter-term priorities because of the market's unpredictable fluctuations. Millennials may want to keep those earmarked funds in reliable assets, "but that doesn't necessarily mean 100% cash," says Maloney. He suggests a mix of cash and high-quality, short-duration bonds that generate some level of interest to help offset inflation."Everyone needs a backup plan and a level of cash on the side that can support it. It's when millennials hold their long-term nest egg in cash that they really give up opportunities."

Maloney recommends having enough cash accessible to cover your expenses during an unexpected job transition or other life event. That could mean anywhere from the equivalent of three to 12 months' income.

"Everyone needs a backup plan and a level of cash on the side that can support it," he says. "It's when millennials hold their long-term nest egg in cash that they really give up opportunities."

Balance in the Middle

Planning for medium-term expenditures, such as college tuition for a child who is currently in elementary school, requires a balanced approach. Early in the investment term, you may expose more of your investment to the stock market, which carries greater potential along with greater risk. Once the child enters high school, you can shift the invested funds toward more reliable short-term assets, which tend to be more stable and less volatile.

There's an allure to holding large amounts of cash, especially if you've come of age in an era of high unemployment and poor market performance. Maloney gets it, but he also understands that to avoid diminishing purchasing power of your savings and to seek real growth, you need to invest some of that money.

"Holding cash may make sense when you're 25 or 30 and desire a safety net or flexibility as you consider different career paths, but it becomes a challenge when you start to put down roots and savings is focused on long-term needs," he says. "You don't want to delay the potential benefits of compounded returns on your long-term savings, as the early years can have the largest impact."