Every financial tool has its pros and cons. Case in point: As a result of the Federal Reserve's sharp and frequent increases to the federal rates in 2022 and 2023, cash investments are now offering yields around 5% — the
This, understandably, may tempt investors to overweight their allocation to cash investments with the intention of being "less risky" and "more conservative." Why,
The short answer is that although cash may feel safe on a visceral level, it is not a risk-free asset in terms of preserving real value. The longer answer could prompt useful advisor-client conversations about the importance of considering the nonsurface-level risks of each asset class in the context of achieving long-term wealth goals.
When are money market funds appropriate?
Money market funds invest in low-risk, highly liquid assets such as Treasury bills, certificates of deposit and short-term bonds with maturities of less than a few years. The objective of money market funds is to provide
However, a closer look at other risk factors is required for long-term investment goals. As of April 4, the seven-day yield of the Fidelity Government Cash Reserves money market (ticker symbol FDRXX) was 5.0%. As of the same date, the opening yield of the five-year U.S. Treasury was 4.331%. Investors holding FDRXX can reasonably expect the fund price to remain at $1 per share, benefit from high liquidity and earn a historically high yield.
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Investors in the five-year Treasury will be subject to bond-price fluctuation, will lock up their funds for a period of five years (unless sold) and will earn a lower yield than that offered by competitive money market funds. In this environment the client may wonder: Why include any
The answer depends on their relevant time horizon. For short-term cash needs, money market funds are a practical option. For long-term goals, there are additional considerations.
Reinvestment risk
While rates on cash of 5%-plus may be available today, such yields may not prevail 12 months from now. Money market rates are closely tied to the federal funds rate, which is adjusted by the Fed in response to economic performance. At the Federal Open Market Committee
As an example, if the Fed decreases the funds rate to 3.5% by the end of 2025, investors in the FDRXX money market fund mentioned above would also likely see their yield decrease to around 3.5%. However, investors in the five-year Treasury would have locked in the 4.331% yield for another three years.
While investors may be tempted to remain in cash with the intention of pivoting to bonds when cash yields decrease, at that point, it will likely be too late. Once the Federal Reserve starts cutting rates, the bond yields will also likely decrease. Therefore, the reinvestment opportunities will be less beneficial than those that could have been secured for a longer duration in prior years.
Price appreciation potential
In addition to the ability to lock in rates for longer periods, bonds also enable potential price appreciation. Consider the five-year Treasury purchased on April 4, at 4.331% and assume that newly issued five-year Treasury rates are 3.5% by the end of 2025. An investor considering these two options will be willing to pay more for the 4.331% bond compared to the newly issued bonds at the prevailing rates of 3.5%. Therefore, the 4.331% bond will trade at a premium.
Of course, price volatility goes in both directions. If interest rates continue to rise, bonds purchased at lower rates will trade at a discount compared to newly issued bonds.
Although investors may be attracted to the benefits of high yields offered by money market funds, for long-term investing goals bonds enable investors to secure relatively higher rates for longer durations, thereby decreasing the reinvestment risk. Further, in periods of federal funds rate decreases, additional price appreciation may result.
Cash vs. inflation
Which brings us back to the hypothetical client's query: Why should I be exposed to the price volatility in the equity market when cash is earning 5%? Many investors feel that cash is a "safe" investment. But in reality, only the nominal value of cash is guaranteed. A $5 bill issued in 1998 is still a $5 bill today, but in 1998 that $5 could buy one ticket to the movies where today it would buy less than half a ticket. Again, consideration of the time horizon is critical. Over short-term periods, cash may be reasonable when compared to inflation. However, over longer terms,
Of the high-stress market periods shown in the table — including 1970s stagflation, the dot-com bubble at the turn of the century and the global financial crisis of 2007-2009 — 2008 represented the lowest single year of inflation-adjusted returns for the S&P 500 at minus-37.1%. Investors in one-month Treasuries in 2008 would have earned 1.5% on an inflation adjusted basis.
Over a one-year period, cash may be viewed as a relative safe haven. However, in the 15-year period ended 2022, inflation adjusted returns for the S&P 500 were 6.3%, and inflation-adjusted one-month Treasury returns were minus-1.7%. Even in 2008, the worst year of market performance since 1937, the 15-year returns of the S&P 500 exceeded those of cash equivalents. Further, the minus-1.7% 15-year one-month Treasury return indicates that the real return of this cash equivalent lost value relative to inflation.
The takeaway is that although equity markets can experience significant price volatility over any short-term period, over longer periods equity markets have historically provided a better strategy for beating inflation. It is easy to forget that equities are just companies. If inflation increases, companies will in turn increase prices, which naturally provides an inflationary hedge. Long-run returns in excess of inflation are the reward for holding equities during volatile periods.
Lost opportunity cost
In addition to inflation, lost opportunity cost is another significant loss factor for holders of excess cash that will never be expressly apparent on an account statement.
Investors who were spooked by the last financial crisis and remained in cash lost real money by remaining on the sidelines. Investment statements do not reflect real returns — further, they do not reflect the cost of nonparticipation. While inflation and opportunity costs may not feel as scary to investors because they are not expressly presented on their financial statements, their impacts on wealth accumulation are very real.
Money market funds and other cash equivalents provide great tools for short-term cash flow needs with little to no principal volatility, as every financial plan requires some level of immediate liquidity. Beyond that amount, I believe that continuing to incorporate bonds and equities in a well-balanced portfolio will help investors approach other, more nuanced risks, more effectively — especially over long time horizons.
