The pros and cons of investing in cash
With interest rates on the rise, the value of cash has been hitting the headlines — and with good reason. CDs, high-interest savings accounts, money market funds and other fixed-income investments are becoming increasingly popular as the federal funds rate hits a 16-year high.
But the question remains, should you invest more in cash? Here, we’ll break down the pros and cons of investing in cash and how it can contribute to your overall investment strategy.
The case for cash
Cash has many uses. Whether it’s providing a safety net for an unexpected expense or loss of employment, achieving a short-term savings goal or paying for everyday expenses, having enough cash on hand is critical to financial stability. However, determining how much cash is “enough” depends on your personal situation. To determine the role of cash in your life and how much you should have, consider the USES acronym:
- Unexpected expenses and emergencies: Cash used for situations like a job loss, a home repair or an unplanned medical expense. For most people, maintaining three to six months of total expenses in emergency savings is appropriate.
- Specific short-term savings goal: Cash dedicated for a goal you want to achieve in the next year or so, such as a wedding or vacation.
- Everyday spending: Cash that funds your lifestyle, including day-to-day spending needs such as groceries, utilities, entertainment and your mortgage/debt payments.
- Source of investment: Cash used as an asset class and as a source for investment opportunities.
Another benefit of cash is that it’s less risky than stocks and bonds. As such, cash should play a small yet important role in a well-balanced investment portfolio (typically between 0% and 5%, depending on your personal situation).
And with the federal funds rate hitting a 16-year high, your cash is working harder than it has been in a while. However, holding cash does have trade-offs too.
The case against cash
While it’s true that the federal funds rate has been putting cash in an attractive position, there’s no guarantee that these high rates will persist. Rates on cash could easily — and quickly — drop, making high-interest rate savings accounts and money market funds less reliable for passive income. Fortunately, if you’re invested in a CD, your interest rate is already locked in, but only until it matures.
Plus, there is a downside to investing in a relatively low-yielding asset. While the federal funds rate is relatively high (4%–6%) right now, cash hasn’t historically competed with the average performance of stocks and bonds over the longer term. The chart below further illustrates the high growth potential of investing in stocks and bonds over time.
Long-term investment returns — Growth of a $1 investment (2002-22)
Source: Morningstar. Hypothetical value of $1 invested beginning 1/1/2002 through 12/31/2022. U.S. small-cap stocks represented by the Russell 2000 TR USD Index. U.S. large-cap stocks represented by the S&P 500 TR USD Index. Developed int’l large-cap stocks represented by the MSCI EAFE NR USD Index. Long-term government bonds represented by the IA SBBI U.S. LY Government Index. U.S. Treasury bills represented by the IA SBBI U.S. 30 Day Tbill Index. Inflation represented by the IA SBBI U.S. Inflation Index. An index is unmanaged and is not available for direct investment. Returns assume reinvestment of interest and dividends back into the index. Returns do not incorporate the impact of trading, liquidity, costs, fees or taxes a client may experience when investing, which may lower performance results. Historic average annual return incorporate the impacts of compounding over time. Small-cap stocks carry greater risk and have greater market fluctuation than large-company stocks. Treasury bills and government bonds are guaranteed by the U.S. government and, if held to maturity, offer a fixed rate of return and fixed principal value. Past performance does not guarantee future results. Diversification does not guarantee a profit or protect against loss.
In this hypothetical example, a $10,000 investment in U.S. large-cap stocks was able to grow to $54,000 (a 440% increase) in just a 20-year period — a stark contrast with the growth potential of investing in cash (which would have grown to about $13,000 using U.S. T-bills).
Another observation from the chart above is that cash doesn’t generally outperform inflation, meaning the rising costs of goods and services can effectively negate most (if not all) of the gains you expect to receive from your cash investments. Thus, relying solely on CDs and other fixed-income investments likely won’t get you where you need to be in terms of reaching your long-term financial goals, like retirement.
The bottom line
Cash plays an important role in our financial lives — and looks like an attractive asset, at least for the time being. It’s important to have enough but not so much that you risk failing to achieve your longer-term aspirations. Reach out to your financial advisor to discuss how to build a cash investment strategy that aligns with your financial goals.