An Illusion of Safety
Over the past 18 months or so, we have seen an extraordinary increase in interest rate earnings from all types of fixed income products. In January of 2022, it was difficult to find bank savings account rates above 0.10%; in today’s market however, you can find FDIC insured savings accounts and money market funds earning more than 5.00%. The US 1-year Treasury bill was earning as little as 0.20% in mid-2021 and is now at 5.50%. For the first time in a long time, there really is income in fixed income. After a lean 16 years, people have a place to put money that will generate a respectable return while remaining safe from stock market volatility. Coupled with stocks and bonds having seen poor returns in 2022 and mixed returns so far in 2023, there might be an impetus to say, why take on equity risk when I get a reasonable return on a safe, stable investment in an FDIC insured savings account, money market fund, or short-term US Treasury product?
Understanding the Risks
While it may seem like a simple choice, there are risks to consider. Yes, the returns on cash and other short-term fixed income products are currently attractive. But it is important to remember that these products typically have substantially lower returns than equity in the long term—and often return less than the rate of inflation. They can exceed – or at least compete – with equity returns in the short term, but historically have underperformed significantly over the long term. It’s vitally important to maintain your equity allocation through thick and thin. Bonds and cash provide stability in a diversified portfolio, but portfolio returns have historically received a significant boost from stocks. It is also important to consider reinvestment risk. Right now, you can earn 5.50% on a 1-year US Treasury bill, but what happens when your 1-year bill matures? Where will rates be at that time? They could very well be lower. The yields and returns in cash and fixed income go up and down, so the 5% you might be currently earning could be back down to earning 3% or less in one year’s time. This is why it is important to hold cash along with short and intermediate-term bonds to reduce reinvestment risk no matter which direction interest rates go.
When Holding Cash Makes Sense
There are two exceptions to holding cash in larger quantities. The first is that you should have an emergency fund to help ride through an economic storm such as loss of a job, unexpected repair costs, family emergencies, etc. Everyone has their own threshold of what this ideal amount is, but there is a point when too much cash is unnecessary and can be harmful to your long-term financial health. The second exception is if you have a planned, large cash expense on the horizon such as a home or car purchase, home remodel, college tuition, etc. The idea here is to take the known amount out of more volatile markets and put it into a stable investment such as a savings account or money market fund. Do not try to be too clever by risking it in equity markets hoping to see some further gain in the short term.
Diversification is Key
Cash, fixed income, and stocks all play a part in your portfolio and financial plan. Stocks are there for long-term growth while fixed income offers stable support when the markets have their inevitable downturns. Cash helps by providing immediate liquidity when needed but should comprise the smallest of your major investment allocations. To be attracted by the siren song of current short-term cash yields will likely lead to long-term disappointment in your overall portfolio performance. Maintaining diversification across all asset classes remains key to achieving your long-term goals and the best way to navigate any challenging waters along the way. https://youtu.be/GItZSxCh_3g