What Is Cash Drag and Why Is It Important?

What is cash drag?

Cash drag is a form of a performance drag on your overall investment portfolio. It is the negative impact of holding cash compared to the potential performance of that cash if invested in the market, considering inflation’s impact on your buying power.

Why is cash drag important?

When looking at your entire financial picture, holding an excessive amount of cash can negatively impact your total returns over time. While it may not “lose” money in the same way that an investment in the stock market can, the buying power of cash held in checking and savings accounts can be negatively impacted by inflation. This impact should be considered when reviewing the performance of your overall financial picture.

It is important to always have a certain level of cash available for planned short-term expenses and emergencies; however, it is crucial to reduce holding excess cash as you are missing out on potential long-term returns.

Look at how inflation has impacted the buying power of $100,000 held in cash over the last 20 years (1/1/2003 to 3/1/2023):

Inflation Adjusted Performance of $100,000 Cash

Starting Value 1/1/2003: $100,000 | Ending Value 3/1/2023: $64,484.41
Monthly PCEPI data obtained from https://fred.stlouisfed.org/series/PCEPI. Data does not reflect any advisory fees.

Now, look at what could have happened if the same $100,000 had been invested in the S&P 500 over that same time (1/1/2003 to 03/1/2023):

Inflation Adjusted Performance of $100,000 Investment in the S&P 500

Starting Value 1/1/2003: $100,000 | Ending Value 3/1/2023: $309,672.12
S&P 500 adjusted close performance data obtained from finance.yahoo.com. Performance adjusted for inflation and adjusted for splits and dividend and/or capital gain distributions. Does not reflect any advisory or investment fees. Past performance does not guarantee future results. The S&P 500 Index is generally considered representative of the U.S. stock market. It is not possible to invest directly in an index. Data is provided for illustrative purposes only, it does not represent actual performance of any client portfolio or account.

What should I do with my excess cash?

Investment decisions are by no means a one-size fits all decision as everyone’s financial picture, goals, and needs are different, but it is important to review your whole financial picture, compare that picture to your long- and short-term goals and see if there is room for improvement by reducing the impact of cash drag on your portfolio.