Why The Return On Cash Doesn’t Matter

July 7th, 2011 by Nelson Smith

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I seriously think I’m going to get kicked out of the personal finance blog-o-net for this post. If personal finance was ancient Greek theology (which it totally is!) online savings accounts would be pretty high on the ol’ god chart. Emergency funds would probably be Zeus. I suspect budgets would be pretty high on the list too, maybe they’d be Apollo. Let’s say that high interest savings accounts would be Aphrodite. Sexy!

Yeah, Greek god metaphors. What’d you expect from me? Quality? At least it’s better than The Simple Dollar.

What the heck was I talking about again? Right, online savings accounts.

First of all, I can understand why every blogger is so high on them, even though it’s (mostly) quite badly disclosed. They love them so much because ING Direct will pay them a referral fee for signing all you morons up. I could start an ING Direct account with the minimum deposit (all of $100) and if I get just one person to sign up for one, I’ve made a 25% return. I’d do all sorts of unsavory things for a guaranteed return of just half that. So I understand the appeal.

Unfortunately, this benefit is quite badly disclosed by most blog authors. Really though, it doesn’t make me too mad. It’s not like they’re encouraging people to buy lottery tickets or to kick a kitten. They’re telling people to deposit money in a bank. Most people in Canada and the United States should be putting more money in the bank. Anything that encourages this is good.

Here’s the problem with these accounts though. Who cares if cash is getting a return?

In a properly constructed portfolio, cash should only be a 5% position. The rest should be invested depending on an investor’s risk tolerance. Bearish on the markets? Then maybe a move into bonds or more conservative stocks is in order. If you’re a perma-bear like David Rosenberg or Meredith Whitney, maybe the majority of your portfolio should be in government bonds. If you have more than 5% of your portfolio in cash, you are sitting on too much cash.

If you shouldn’t be sitting on much cash, then what’s the purpose of trying to get a higher return on it? Say an investor has a $200,000 portfolio, with an average yield of 4%. If she follows my 5% cash rule, here’s her results:

$190,000 @ 4% = $7600

$10,000 @ 2% = $200

Percentage of total income: 2.63%.

Congratulations, you’ve turned a portfolio from a yield of 3.8% to 3.9%. I guess that’s… something?

Okay, I’ll give you high interest savings accounters some credit. If we both had $10,000 in cash, you’d end up with $125 per year more than I would, since my cash sits in a redeemable GIC at my local credit union with the cute teller girls, yielding me an impressively crappy 0.75%. If you add that up over 30 years, you’d end up with over $3000 more than what I have. You’d probably take great pleasure in pointing this out to me, which would undoubtedly annoy me.

Here’s the point of this whole post. I bet 99% of the people who have ING Direct accounts don’t even have enough cash in them to matter. If you have $1000 in cash, you’re making $20 whole bucks a year. Hell, I’ve wasted more on gag gifts and buffet dinners this week, and I’m a cheap bastard. Unless you’re consistently sitting on over $5000 in cash, the interest rate doesn’t matter. People are really g00d (or bad, depending on your perspective) at pissing away money on crap. And then these same people rejoice about the benefits of the all mighty online bank.

Secondly, if you’re really worrying about the return on your cash, that’s probably indicator number 1 that you’re sitting on too much of it. I read finance blogs where the author is sitting on tens of thousands of dollars of cash, that number accounting for a large percentage of their net worth. Cash is not an investment. Even in the precious high interest savings account it’s slowly losing value to inflation. That is a bad financial decision. There are investments that you can buy that are almost as safe as cash, but offer a greater return. Maybe one day I’ll tell you what they are.

I sit on a certain percentage of cash, like every person should. Most people call it an emergency fund. I look at it more as an opportunity fund. I just about fully drain my cash reserves several times a year. Sometimes, I have to pay big things like property taxes or insurance. Other times, something goes wrong in a rental property that costs me thousands. And sometimes great opportunities come along that I just can’t resist. This is why everybody should sit on some cash.

But the point of cash isn’t to make a return. The point of cash is liquidity. Technology has made cash sitting in an online account accessible almost instantly. Liquidity isn’t really a big problem for an online account. It’s not that online savings accounts are bad. It’s just, for most people, they’re a giant waste of time. Unless you’re sitting on a nice sized net worth, the return on your cash just doesn’t matter.