In times of market uncertainty, investors often seek the safety of cash. This has been true over the past several years as markets have swung due to the pandemic, geopolitical events, Fed rate hikes, inflation, gridlock in Washington, technology trends, and more. More recently, the possibility of worse-than-expected inflation and a delay 0f the first Fed rate cut have led to renewed investor concerns. At the same time, interest rates on cash are at their highest levels in decades, making it appear that there are attractive “risk-free” returns. What role should cash play in investor portfolios today?
After over a decade of historically low interest rates, higher cash yields are a welcome development for many investors. Interest rates are higher across all cash instruments including many savings accounts, certificates of deposit, and money market funds, just to name a few. This is because the Fed raised rates rapidly from early 2022 to mid-2023 and has kept the federal funds rate in a range of 5.25% to 5.50% since last July. After the recent Fed meeting, Fed Chair Jerome Powell noted that it “will take longer than previously expected” to gain greater confidence that inflation is on the right path, implying that policy rates could stay higher for longer.
Money market funds have experienced significant inflows
These dynamics have led many investors to hold more cash than in the past. Money market funds, for instance, have attracted inflows with total assets reaching new all-time highs of $6 trillion. This is more than double the assets held in money market funds prior to the pandemic when interest rates were near zero for the better part of a decade. As the accompanying chart shows, money market fund assets have typically grown in times of economic distress or when interest rates have been high.
Cash is an essential part of any financial and investment plan. From a financial planning perspective, cash provides the liquidity needed to cover expenses and important life events. The down payment on an upcoming home purchase, for instance, should primarily be held in cash-like instruments. Similarly, it's important to have enough cash to serve as an emergency fund in case of unexpected personal events such as injury or illness or broader events such as an economic downturn. From an investment standpoint, cash can also serve important roles including reducing overall portfolio risk and by allowing investors to take advantage of attractive market prices.
Inflation erodes the value of cash
While cash is important, it can become problematic when investors hold too much cash. This is because cash is not truly risk-free for two important reasons. First, inflation quietly erodes the purchasing power of cash over time. So even if yields appear to be high, the real value of your money could decline. As the accompanying chart shows, the inflation-adjusted income on cash has consistently been negative when considering average certificate of deposit rates.
While there are many cash instruments that could generate more yield than these averages, the problem is that these rates are not "locked in." By definition, short-term rates need to be rolled over often as instruments mature and expire, introducing what is known as "reinvestment risk," or the idea that future rates may not be as attractive. Even in the best case scenario, investors need to actively manage these instruments to ensure that they are still receiving the level of rates they expect.
The second challenge with holding excess cash is the opportunity cost of not investing in stocks or bonds. Just as interest rates have risen for cash, yields have also jumped across many types of bonds. The average yield on U.S. investment grade corporate bonds, for instance, is now 5.5% - far more attractive than the average of 3.7% since 2009. Unlike cash, these yields are longer-term in nature and these bonds could experience price appreciation if rates do decline.
Similarly, the stock market has performed extremely well despite many investor concerns over the past few years. The S&P 500 is still up 8% with dividends and has gained about 47% since the market bottom in 2022. While the past is no guarantee of the future, these returns have far outpaced inflation and would have helped to offset the erosion of purchasing power across a portfolio.
Stocks and bonds have outpaced inflation over history
The prospects for cash will only worsen if the Fed does begin to cut rates later this year. Investors would be forced to reinvest their cash either at lower interest rates or in stocks and bonds whose prices would most likely have already risen. The possibility of falling rates has been an important driver of the overall stock market that will likely continue.
The accompanying chart makes this opportunity cost clear. Due to inflation, what cost one dollar in 1926 now costs $17. However, the stock market has significantly outpaced inflation over long periods of time. A hypothetical one dollar investment in the stock market in 1926 would be worth over $13,000 today. A similar investment in long-term bonds would be worth $106, also outpacing inflation.
Thus, while short-term investments can play important roles in financial plans and portfolios, it's critical in today's market environment to avoid holding cash for the wrong reasons. Market fear and high short-term rates have driven significant flows into cash and cash-like instruments. While these may make sense for short periods, history shows that they are not the foundation of long-term financial success.
The bottom line? Investors should review their cash holdings as the Fed prepares to cut rates. In the long run, holding a proper allocation of stocks, bonds, and cash is still the best way to achieve financial goals.
Pursuit Planning and Investment, LLC is a fee-only fiduciary financial planning firm in Portland, Oregon. We offer virtual financial planning services for working professionals. Feel free to review our services and place a commitment-free 30-minute discovery meeting on the calendar. Plan your pursuit!
Have something on your mind?
Pursuit Planning and Investments, LLC (“PPI”) is a registered investment advisor offering advisory services in the States of Oregon and Indiana and in other jurisdictions where exempted. Registration does not imply a certain level of skill or training. All views, expressions, and opinions included in this communication are subject to change. This communication is not intended as an offer or solicitation to buy, hold or sell any financial instrument or investment advisory services. Any information provided has been obtained from sources considered reliable, but we do not guarantee the accuracy or the completeness of any description of securities, markets or developments mentioned. We may, from time to time, have a position in the securities mentioned and may execute transactions that may not be consistent with this communication's conclusions. Past results do not guarantee future results. Please contact us at 971-803-5948 if there is any change in your financial situation, needs, goals or objectives, or if you wish to initiate any restrictions on the management of the account or modify existing restrictions. Additionally, we recommend you compare any account reports from PPI with the account statements from your Custodian. Please notify us if you do not receive statements from your Custodian on at least a quarterly basis. Our current disclosure brochure, Form ADV Part 2, is available for your review upon request, and on our website, www.planyourpursuit.com. This disclosure brochure, or a summary of material changes made, is also provided to our clients on an annual basis.
This communication is for informational purposes only and is not intended as tax, accounting or legal advice, as an offer or solicitation of an offer to buy or sell, or as an endorsement of any company, security, fund, or other securities or non-securities offering. This communication should not be relied upon as the sole factor in an investment making decision.
Past performance is no indication of future results. Investment in securities involves significant risk and has the potential for partial or complete loss of funds invested. It should not be assumed that any recommendations made will be profitable or equal the performance noted in this publication.
The information herein is provided “AS IS” and without warranties of any kind either express or implied. To the fullest extent permissible pursuant to applicable laws, Pursuit Planning and Investments, LLC (referred to as “PPI”) disclaims all warranties, express or implied, including, but not limited to, implied warranties of merchantability, non-infringement, and suitability for a particular purpose.
All opinions and estimates constitute PPI’s judgement as of the date of this communication and are subject to change without notice. PPI does not warrant that the information will be free from error. The information should not be relied upon for purposes of transacting securities or other investments. Your use of the information is at your sole risk. Under no circumstances shall PPI be liable for any direct, indirect, special or consequential damages that result from the use of, or the inability to use, the information provided herein, even if PPI or a PPI authorized representative has been advised of the possibility of such damages. Information contained herein should not be considered a solicitation to buy, an offer to sell, or a recommendation of any security in any jurisdiction where such offer, solicitation, or recommendation would be unlawful or unauthorized.
Comentarios