Cash and cash equivalent investments can be a great tool to use for short-term goals and needs. When people refer to cash and cash equivalents in the investing world, they are often referring to money market mutual funds, CDs, US Treasury bills, and savings accounts.
With the Federal Reserve having raised rates so many times over the past year and a half, yields on these cash/cash equivalents have increased and look more attractive. With so much attention on these higher rates that are available, some people are wondering, “Why not move more to cash? I’m earning a good return, and I don’t have to deal with volatility.”
While this might sound good on the surface, it’s important to remember that there are several reasons to be skeptical of this kind of thinking.
Yields on Cash Are Variable - They Won’t Last Forever
The Federal Reserve won’t keep raising rates indefinitely. At some point, it’s likely rates will come back down. Just as quickly as these yields went up, they can go down. A good illustration of this comes from a recent piece by Hartford Funds, which shows how rates have dropped significantly during certain periods in the last 50 years.
Furthermore, a recent article from Capital Group's Mike Gitlin notes, “History shows that in the 18 months after the Fed ended hikes in the last four cycles, yields on cash-like investments have traditionally decayed rapidly. The 3-month Treasury yield, a benchmark Treasury security with a yield similar to cash-like investments, fell an average of 2.5%. If history were to repeat itself, money market fund yields would decline, and investors would be better served by being actively invested in stocks and bonds.”
A recent, interesting example of how yields can change quickly is I-bonds. I-bonds are US government bonds that adjust the rate they pay based on recent inflation. Last year, everyone was talking about them as one of the greatest investment opportunities out there. Once inflation came back down to earth this year, the talk about I-bonds has died down dramatically. We must be careful to remember that the current environment won’t persist forever. As investors, we have to think past the next few months.
Inflation and Purchasing Power
If you look back over time, cash and cash equivalents have often lost purchasing power to inflation. Although it feels “safer” to hold onto cash, it may be more risky than you think due to the potential for losing purchasing power over time.
The following chart from Hartford Funds helps us understand that “it’s important for investors to realize that cash investments such as CDs typically don’t generate a positive return after factoring in taxes and inflation.”
Stocks and Bonds Have Historically Provided a Lot More Return Than Cash
If you look at historical returns over time, stocks have provided a lot more than cash. A chart from a recent Morningstar article by Danny Noonan shows how this average return disparity becomes larger as the time horizon increases.
Bonds have also historically beat out returns on cash and cash equivalents over time. A chart from the aforementioned Hartford Funds piece helps illustrate how bonds (and stocks) have outperformed cash over time.
[Bonds are represented by the IA SBBI LT Government Index, which measures the performance of a single issue of outstanding US Treasury notes with a maturity term of around 55 years. Cash is represented by IA SSBI US 30 Day T-Bill Index, which tracks 30=day Treasury bills. CD rates are based on 3-Month CD rates from the Federal Reserve Bank of St. Louis. Data begins June 1964. Stocks are represented by the S&P 500 Index., which is a market capitalization-weighted price index composed of 500 widely held common stocks, using data circulated by Ibbotson Associates.]
Additionally, now may be a time when it’s even more important to consider the potential outperformance of stocks and bonds over cash, due to the high probability that we are near peak rates. The chart below from the Capital Group emphasizes this point.
For short-term needs and goals (money needs in the next year or so), it’s great to use cash and cash equivalents. But as you start to extend your time horizon, it’s wise to consider bonds and stocks. As Danny Noonan of Morningstar said, “While holding cash may make you feel good in the short term, the long-term track record of that decision could have a major negative impact.”
Regardless of age or situation, investors tend to have a difficult time thinking past the next few months. If you have money that you don’t plan to use in the near term, now may be a great time to contemplate taking some cash off the sidelines and deploying it in bonds and stocks.
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