If you are reading this, it means that you have already crossed one big hurdle. You have already started saving for your retirement! Well done! The next big question is: are you saving in cash or are you investing the money?
A recent survey has shown that many people saving for retirement are leaving all their savings in cash. Many have become risk-averse. And I don’t blame them as many saw their shares halve in value during the financial crises. This left them with a bad taste of the stock market and has led many to stop investing altogether. Many are now keeping all their money in cash for fear of losing even more to the stock market. But having all your money in cash is not good for you.
Why having all your money in cash is a bad idea.
There are good reasons to have some of your savings in cash. Cash is liquid and readily available. There is also less of a chance of cash losing its value by 50% or more in a short amount of time. So why is cash actually a bad idea?
The current interest rate on cash that is being paid out by savings account ranges between 1% – 1.5%. Inflation has averaged close to 2%. So this means that by having your savings in cash, your money is growing by only 1.5% each year whilst the value of goods and services is going up by close to 2%. You see, by saving cash, you are actually losing money!
You may think you are avoiding risk by staying in cash but in actual fact, you are just exposed to a different kind of risk – inflation risk!
Investing money on the other hand in a well constructed portfolio usually has gains in excess of the inflation rate. So with investing, unlike cash, you actually make money year on year.
If you had actually kept your shares right through the financial crises and held them today, you will actually be sitting on more money today than you would have done before the crash.
Now I’m not saying put all your money in stocks. Instead, it is important that you have a well diversified port of stocks and bonds. The proportion you invest between stocks and bonds will be determined by your risk preference and time horizon. The typical rule of thumb is that you should have 120 minus your age in stocks.
If you have a lot of money in cash, it is also not wise to throw it all at once in stocks. It is better to pound cost average over a period of time. Read more on pound cost averaging and other ways to mitigate your stock market risk by reading this article.