Loss aversion and our addiction to short term gratification
Mitchell Barr, Client Associate
The holidays are finally upon us and that can only mean one thing: It’s time to overindulge in all your favorite holiday dishes. Bring on the calorie bomb that has two sticks of butter and a pound of sugar in it! You know it’s horrible for your waistline, but you eat too much of it, anyway. A two-hour nap is usually required to recover from the sugar crash, but there’s a warm fuzzy feeling in your stomach and everything is all right in the world. There’s really not much harm in overindulging in a holiday treat like apple pie (my personal favorite). You can go to the gym the next day and punish yourself until you feel like a picture of health again. Self-abuse, however, can be much more detrimental when it comes to dealing with your money.
Cash is king
Consider one of the most common problems investors face: How much cash should you hold to sleep well at night, but avoid losing out on potential growth by not investing it? From a purely financial perspective, it’s been drilled into our heads that three to six months of living expenses is enough cash on hand. That may sound simple, but unfortunately, the same feelings that cause us to eat too much apple pie also cause us to hold too much cash. People like to have cash because it makes them feel safe, and many times, they will hold too much of it even when they know that they could be missing out on investing in the next Amazon (AMZN). Why do we do that?
I want it now!
One reason is because we are addicted to short-term pleasure, which makes it very difficult to look at the bigger picture. Being able to sleep comfortably at night is a much stronger behavior driver than an investment that may not pay off until the distant future. Apple pie wins over six pack abs almost every time. It takes tremendous self-discipline to delay gratification. Then there is the fact that losing money hurts a lot more than making it feels good. Nobody likes to lose money. We are willing to hold cash because we feel like it eliminates the possibility of losing it, even at the expense of missing out on future growth.
The cost of cash
One problem with this logic is that inflation eats away at any returns you may get in a money market or other cash equivalent. Inflation simply means that prices go up over the long term. It’s like the Coca Cola signs you see from the 1920’s showing a bottle cost five cents. The same bottle of Coke hasn’t changed for 100 years but now it will cost you $1.50. Inflation is the biggest threat to investing that nobody talks about, because it’s so hard to notice. But if you have cash sitting in a money market account your “real” return may net out to zero because even though you are receiving a modest rate of interest, prices are going up too.
Future growth is also a huge lost opportunity if you hold too much cash. The graphic below shows how often you would have been better off investing in the stock market than in treasury bills (a proxy for cash) over different lengths of time. The takeaway is, even holding cash for one year would have left you worse off than investing it 69% of the time. And, the longer you hold, the higher the probability you will be missing out.
Source: Dimensional Fund Advisors
We obviously need to have some cash around, but if you are a long-term investor, who is scared to invest cash, your emotions may be getting the best of you. It’s important to understand that the stock market will work for you over long periods of time. When it comes to holding cash, the question you need to ask yourself is, how much are you willing to give up for an extra slice of pie?
Mitch writes the popular blog, The Money Monkey, where he focuses on common mental mistakes made by investors, how to avoid being your own worst financial enemy, and thinking about investing in new ways.