Financial Quotient

What is the 'cash drag' effect?

WHAT DO YOU MEAN?

The "cash drag" effect is a type of performance drag in an investor's portfolio that is caused by low - or even negative - returns from holding cash, after accounting for inflation.

Both cash and cash-equivalent securities, such as short-term government bonds, have the propensity to cause a portfolio to underperform.

When compared with the relatively higher rate of returns earned from investing in the stock market, the low to negative returns from holding cash will pull down the overall returns rate of a portfolio.

The "cash drag" effect is best understood as an opportunity cost, as investors could have potentially earned far greater returns if they had chosen instead to allocate their capital in other products that yield higher returns, such as equities.

WHY IS IT IMPORTANT?

It may seem like a pragmatic decision to allocate a chunk of savings to cash or cash-equivalent products.

However, in the long run, holding a significant portion of your savings in cash could have devastating consequences for your portfolio.

Although cash is often touted as a low-risk investment, holding cash in your portfolio runs an inflationary risk as the value of cash will slowly diminish over time.

For retirees, the "cash drag" effect could prevent them from having a high safe withdrawal rate.

A mix of bonds and cash will likely deliver about 2 to 3 per cent in annual returns. As such, a safe withdrawal rate of 5 per cent would be impossible if a portfolio has significant holdings in cash.

To put the "cash drag" effect into perspective, let's assume that an investor has 25 per cent of his portfolio, worth $1 million, held in cash.

Now, if the annual rate of return of his cash holdings yields 1 per cent while the general stock market returns 8 per cent, then the investor would have a "cash drag" effect of $17,500 just in his first year of investing. Over a 30-year period, this will balloon to almost $1.9 million - twice as much as his initial investment.

IF YOU WANT TO USE THE TERM, JUST SAY: "Investors looking to maximise their return on investment should try to avoid the 'cash drag' effect."


• The author is the fund manager and co-founder of Aggregate Asset Management.

A version of this article appeared in the print edition of The Sunday Times on August 04, 2019, with the headline 'What is the 'cash drag' effect?'. Print Edition | Subscribe