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with a 5% yield on cash why would anyone
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want to invest in stocks and bonds I
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know that cash feels good because it's
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nominal value is stable it feels safe
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but it's counterintuitively extremely
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risky for long-term investors cash is a
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poor hedge against falling expected
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returns it is historically much more
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likely to lose purchasing power than
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stocks and bonds in the long run and
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real Returns on stocks and bonds have
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historically been higher at higher
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levels of real interest rates making
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cash a relatively poor long-term invest
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M even when interest rates are high I'm
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Ben Felix portfolio manager at pwl
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Capital and I'm going to tell you why
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cash is a terrible long-term investment
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I want to be clear to start that this
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video is about money that you can direct
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toward long-term Investments keeping
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cash set aside in an emergency fund is
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often a good idea and that cash should
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not be kept in anything volatile since
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it's set aside to cover short-term needs
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highin savings accounts currently
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available to retail investors through
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highin savings account ETFs are paying
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more than 5% in annual interest at this
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moment when you can get a 5% yield on
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your cash stocks and bonds might seem to
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lose some of their luster as long-term
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Investments It is Well documented that
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investors exposure to risky assets is
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sensitive to interest rates when
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interest rates are lower investors reach
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for yield in riskier assets and when
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interest rates are higher they reduce
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their exposure cash is safe dayto day
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when markets are volatile cash
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especially in a country like Canada is
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going to be there when you need it while
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stocks and bonds change in value often
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materially every day investors are
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always worried about the next market
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crash probably more worried than they
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should be and this results in reduced
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exposure to risky assets like stocks
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risky assets sound risky and they are
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but risk is not always a bad thing in
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investing most investors think about
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cash or short-term government bills as
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the risk-free asset in managing their
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portfolios but this is only applicable
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to a short-term investor the first thing
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to understand about cash returns is that
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while the value of cash is stable the
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expected return on cash is unpredictable
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the current 5% yield on cash is
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definitely attractive but the
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relationship between the current
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short-term return on cash and the
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long-term return on cash is at best very
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noisy based on regression analysis of
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historical data we attribute only a
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small portion of the expected return on
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cash to its current yield when we run
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financial planning projections at pwl
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Capital a 5% cash yield today does not
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mean a 5% cash yield tomorrow and this
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is a problem for long-term investors
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short-term volatility matters a lot to
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short-term investors if you wake up
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tomorrow and you have 20% less money in
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the bank account that you're going to
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use to buy lunch you will not be happy
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on the other hand if you wake up and
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your cash is earning 3% interest instead
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of 5% you can still afford your lunch
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long-term investors care less about
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volatility and more about how their
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expected returns change with volatility
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for example a drop in the value of a
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long-term portfolio that is offset by an
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increase in the portfolio's expected
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return is actually irrelevant to a
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long-term investor based on this the
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risk-free asset for a long-term investor
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is not cash it's a long-term inflation
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index bond in simple terms when you lock
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in your inflation index future coupon
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payments from your bond you don't really
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care about the price of your bond in the
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interm since a drop in prices is offset
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by an increase in expected return you
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can use the coupon payments to buy your
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lunch even if the bond price Falls by
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20% now what's interesting is that
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long-term inflation index bond prices
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can be extremely volatile as we saw in
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2022 so a short-term investor would
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probably call them risky cash does not
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change in price in response to changes
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in interest rates its nominal value is
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very stable day to-day this is great for
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a short-term investor since they want to
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be able to spend their cash today and
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tomorrow but it leaves long-term
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investors exposed to the risk of falling
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expected returns expected returns matter
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a lot for long-term investors since
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they're relying on their assets to
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generate returns far into the future if
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you need $50,000 per year for the next
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30 Years and you buy a 30-year Bond
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you're set even if interest rates fall
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but if you buy a one-year Bond at 5% and
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then interest rates fall to say 3% you
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have a massive shortfall to fund for the
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next 29 years if expected returns fall
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long-term bonds hedge your ability to
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afford your lifestyle in the future
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while cash offers no such protection in
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this way stocks are sort of like bonds
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when their prices fall their expected
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returns rise this also means that like
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bonds stocks are less risky for a
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long-term investor than their short-term
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price fluctuations would otherwise
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suggest when expected returns fall
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long-term asset prices like those of
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stocks and long-term bonds will tend to
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rise offsetting the effects of lower
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expected returns for long-term investors
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cash also has lower expected returns
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than stocks and bonds in most
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environments since cash does not command
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a risk premium stocks and bonds are
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expected to earn a premium above and
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beyond the return on cash to compensate
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investors for taking risk based on this
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we should expect that when interest
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rates increase expected Returns on
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stocks and bonds also increase and this
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is exactly what we see in the data in a
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global sample of countries with
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continuous histories back to 1900 5-year
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Returns on stocks and bonds sorted on
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their starting real interest rates
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increase with higher starting interest
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rates this suggests that as Theory would
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predict the risk premiums for stocks and
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bonds above cash are persistent even at
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higher interest rates this is important
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even if interest rates are high expected
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returns are being left on the table when
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you hold cash this consistently lower
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expected return on cash means it will be
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much more challenging to meet your
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long-term financial goals you'll need to
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expect to save more or spend less in the
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future to compensate but the lower
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expected returns also increase the risk
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of losing purchasing power in the long
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run investors have historically been
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significantly more likely to lose
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purchasing power holding cash measured
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by short-term government bills than
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holding stocks or Bonds in the long run
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in a broad sample of 38 developed
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markets from 1890 to 2019 the bootstrap
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estimate of 30-year real loss
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probabilities for government bills is
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37% compared to 27% for intermediate
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bonds 133% for domestic stocks and 4%
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for international stocks not only has
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the probability of loss been greater but
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the magnitude has as well importantly
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this is only true at longer Horizons at
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Short Horizons as you would hope cash
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has been safer than stocks and bonds if
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you hear this and think that you'll hang
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tight sitting on cash until the market
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drops and then invest in stocks I have a
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word of caution when we've looked at the
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idea of buying the dip sitting on cash
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until a market drop of 10 or 20% and
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then investing in stocks we found that
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buying the dip Trails investing a lump
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sum most of the time and by a wide
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margin on average this finding is
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consistent with stocks and bonds having
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higher expected returns than Cash Cash
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yields are currently High potentially
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enticing long-term investors to hold
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cash rather than investing in stocks and
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bonds the problem is that the expected
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return on cash is unpredictable and cash
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does not offer a hedge against falling
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expected returns which can be materially
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detrimental to long-term investors cash
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also has lower expected returns than
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stocks and bonds in all interest rate
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environments and is much more likely to
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lose purchasing power in the long run
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holding cash can feel really good and
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even better at 5% but long longterm
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investors are likely better off in
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stocks and bonds in the long run thanks
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for watching I'm Ben Felix portfolio
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manager at pwl Capital if you enjoyed
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this video please share it with someone
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who has their long-term Investments
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sitting in cash
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[Music]