What to Do When You Have Too Much Cash

This article is published with permission from InvestmentU.com.

There are quite a few Americans who have too much cash. It's a nice problem to have. But I'm not talking about the 1-percenters or anyone else you may think of as rich.

I'm talking about the average American.

Now, the average American may not feel especially wealthy, but the fact is he has too much cash — at least in proportion to his overall portfolios.

According to a study by State Street, the average investor has 36% of his assets in cash, up from 26% 2 years ago.

As investors were raising cash, the stock market climbed 59% since the beginning of 2012. If you had $100,000 in investable assets and were like the typical American with 26% in cash back then, you missed out on at least $15,340 in gains. And, if like the average American, you raised your cash holdings by 10%, you missed out on even more.

When to raise cash

There is nothing wrong with holding cash when you need it in the near future. If you're planning to buy a house or send a kid to college, or require funds for living expenses in retirement, you should absolutely convert some of your investments to cash.

You don't want to have your money at risk in the market if you have bills that have to be paid. Liquidate some of your investments to make sure that your expenses are covered.

But there is actually a problem in holding too much cash.

Someone holding too much cash is likely to miss out on market gains and probably will not grow his nest egg large enough to fund his needs.

Millions of investors sold during the last bear market as the financial crisis unraveled. Very few of them got back in during 2009 or even 2010.

In fact, more money was pulled out of stock funds between January 2008 and March 2009 than has been put back in since March 2009.

During those 15 months, $270 billion was taken out of equity funds. From 2008 to 2012, $550 billion came out. Only $216 billion has found its way back in since January 2013.

You might think you're being safe by holding on to so much cash, but not only will it be a drag on your portfolio's performance, these days your cash actually loses buying power.

Most money market funds pay about a tenth of a percentage point. That's not nearly enough to keep up with inflation, even at today's low 1.5%. (I keep my cash in EverBank's Yield Pledge Money Market, which pays considerably more.)

Getting wealthy isn't just about accumulating assets; it's about increasing your buying power. You want your money generating a higher return than inflation, whether inflation is at 1.5% or 15%.

Here's what I mean. If you're earning 0.1% in your money market account and inflation is 1.5%, then next year your dollars will buy only $0.986 worth of today's goods and services.

And that's the official inflation rate. We all know there are plenty of things, like airfares and tuition, climbing much faster than 1.5%.

On the other hand, if you're earning 2% and the inflation rate is 1.5%, your money can now buy $1.005 of tomorrow's goods and services. Your buying power has increased.

That's my definition of wealth. It's not just a flat number to feel comfortable. It's the increase of buying power.

Solutions for too much cash

If you're sitting on too much cash and want to generate a better return, there are a few things you can do:

Determine how much cash you really need

You should always have about 6 months of living expenses in cash in case of an emergency.

Determine your near-term needs

For example, if you expect to put $25,000 down on a house in the next 2 years, rather than leaving it in cash, consider a CD or Treasury. The rates are still abysmally low, but you'll still earn more than you will with most savings accounts or money markets (except for the EverBank money market account I mentioned earlier). Only lock up your money if you know exactly when you'll need it.

Take it slow

The reason you're sitting in so much cash is likely because you're afraid to buy into this market at all-time highs and 5 years into a bull market. That's a reasonable concern.

But how do you know the bull isn't going to go higher for another 5 years? It's happened before. If you don't need some of your cash anytime soon, put it to work in the market in dribs and drabs. Add some stock exposure every month or quarter, a little at a time. In the event of a sell-off, you won't have all of your capital in the market at once. But if stocks go higher, you'll still be participating and generating a greater return than if your funds were sitting in the bank.

Many investors are still shy from the drubbing they took in 2008 or feel that it's too late to get into the market now. That kind of scared thinking is going to cost them when their portfolios don't generate the kind of returns they need to meet their goals. That's what investors should really be afraid of.

Too much cash actually can be a problem.

Marc Lichtenfeld is the chief income strategist at Investment U. See more articles by Marc here.

The information contained in this article should not be construed as investment advice or as a solicitation to buy or sell any stock. Nothing published by Physician’s Money Digest should be considered personalized investment advice. Physician’s Money Digest, its writers and editors, and Intellisphere LLC and its employees are not responsible for errors and/or omissions.