When markets are volatile, many investors now have a large portion of their portfolio invested in cash. This reduction in risk may come at a cost.

Do you have too much money invested in cash or cash equivalents, like money market accounts, CDs, or stable value funds? Recent surveys have indicated that a growing portion of investors, particularly young investors in their 20s and 30s,have a surprising amount of their portfolio invested in cash - as much as 30% and this proportion seems to be growing. Born in the 1980s and 1990s, these generation Y investors came of age during the dot com crash and the housing bubble. Fearful of the markets, these young investors define their investment strategy primarily in terms of preserving capital. While playing it safe can protect you against the downswings in the market, market risk is not an investor’s only concern.

Inflation Risk

Investing some portion of your portfolio in cash makes sense for all investors.All investors should have a fully funded emergency fund that can cover three to six months of expenses if they were to lose their jobs or experience some other type of emergency. Beyond this emergency cash, cash plays a role in any proper asset allocation because it provides liquidity (easy access) and helps to ensure the preservation of capital. But most experts would anticipate that for young investors cash will represent only 5 - 10% of their investment portfolio. While this percent will grow as an investor approaches retirement, cash holdings will always typically play a back seat to your investments in stocks and bonds.Why? While your cash holdings are unlikely to lose money, their return is simply too low. Inflation is a key problem. Inflation has historically averaged about 3%each year, which means that every year the things you need to buy are getting more expensive. If inflation is increasing at 3% but your investments are earning less than 2% in a money market or CD, your purchasing power is actually decreasing over time. Although stocks are typically the riskiest type of investment because they can go up and down at any time, they have the highest potential return and have consistently outpaced inflation since the 1940s.

Readiness Risk

Besides inflation, investing too large a portion of your portfolio in cash can also increase the risk that you are not prepared for retirement. While the “under the mattress” investment approach can reduce the risk that an investor loses money, the problem is that most people cannot fund their retirement out of their own pocket. If a 30 year old wants $500,000 in their retirement account when they retire, for instance, they will have to save about $1,000 each month if they put their money in a simple savings account earning 1% interest. In contrast, if they invest their money in a balanced portfolio with a mix of stocks and bonds and realize an average return of 6%, they would only need to save $325 per month. In order to have sufficient savings to fund their retirement, most investors need reasonable investment returns in order to have any hope of reaching their retirement savings objectives. Keeping too large a portion of your portfolio in cash may protect you from market risk but leave you very vulnerable to an under-funded retirement account. Taking some risks in the short-term may be required to meet your long-term financial goals.

The good news is that the longer your time horizon, the less market risk is a factor. What really matters is how much you’ll be worth 10, 20, or 30 years from now, when you need to spend your money. If you don’t need your money in the next 5 or so years, you can keep your eye on the long-term patterns of growth while recognizing that some years may give you temporary setbacks. If you have the luxury of time, you have the opportunity to be more aggressive with the hope of earning much larger returns. By avoiding the markets, young investors may be foregoing decades of compounding interest that would help to ensure their long-term retirement readiness.

A Diversified Portfolio

Your asset allocation, or the proportion of your money you invest in stocks, bonds, and cash equivalents, should be a function of both your age and your tolerance for risk. If the thought that you may lose money keeps you up at night, then you will be more comfortable with a more conservative asset allocation. But that does not necessarily mean that you should have a large portion of your holdings in money market accounts or stable value funds. While we often refer to stocks generically as being“risky”, not all stocks are created equal in terms of risk. Similarly, some bonds may be a lot riskier than other types of bonds.Short-term bonds will have less volatility than long term bonds because there is less uncertainty about changing interest rates and the risks of non-payment. Large cap stock funds tend to be less risky than small cap stock funds because larger companies tend to be more stable than smaller, newer companies. Your Plan’s investment menu has a wide variety of investment choices that are just right for all types of investors. Regardless of your risk tolerance, it is possible to make appropriate investment choices that balance your desire for safety with your need for investment returns.