Why Invest when Cash is Earning 5%?

Why Invest when Cash is Earning 5%?

January 29, 2024

Every financial tool has its pros and cons. As a result of the Fed’s sharp and frequent increases to the Federal rates in 2022 and 2023, cash investments are now offering yields around 5% - the highest in multiple decades. Understandably, investors may be tempted to overweight their allocation to cash with the intention of being “less risky” and “more conservative.” However, for long-term financial plans, it is important to consider the non-surface level risks of each asset class.

What is a money market and when is it appropriate?

Money market funds invest in low risk, highly liquid assets, such as Treasury Bills (T-Bills), certificates of deposits and short-term bonds with maturities of less than a few years. The objectives of money market funds are to provide the following: stability, liquidity, and income.

  • Stability – Money market funds are generally priced at $1/ share.[1]Therefore, no principal growth is intended. Any growth in the account balance will be driven by the income yield. As another example of the stability of money market funds, the T-Bill rate is also called the Risk-Free rate.

  • Liquidity – Unlike certificates of deposit, cash may be withdrawn from money market funds at any time without incurring penalties.
  • Income – In general, money market funds typically offer higher yields than traditional savings accounts.

Due to the above three factors, money market funds may be an ideal option for short-term cash flow needs. However, a closer look at other risk factors is required for long-term investment considerations.  

Why have any allocation to bonds if money market yields are comparable, and in many instances higher, than those of bonds?

As of January 23, 2024, the 7-day yield of the Fidelity Government Cash Reserves money market (ticker symbol FDRXX) was 5.02%.[2] As of the same date, the opening yield of the 5-Year US Treasury was 4.044%.[3] Investors holding FDRXX can reasonably expect the fund price to remain at $1/ share, benefit from high liquidity, and earn a historically high yield. Investors in the 5-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, why include any bonds in the portfolio? The answer depends on the 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%+ may be available today, such yields may not prevail twelve months from now. Money market rates are closely tied to the Federal Funds rate, which is adjusted by the Federal Reserve in response to economic performance. Throughout 2022 and 2023, the Fed initiated the below rate increases.[4]

Rate increases

At the Federal Open Market Committee meeting on December 13, 2023, Federal Reserve members indicated there may be rate cuts in 2024 and confirmed that the Federal Funds rate long-run outlook remains between 2.0% to 2.25%.[5]  

As a hypothetical example, if the Fed decreases the Funds rate to 3.5% by the end of 2025, investors in the above mentioned FDRXX money market fund would also likely see their yield decrease to around 3.5%. However, investors in the 5-Year Treasury would have locked in the 4.044% 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 5 Year Treasury purchased on January 23, 2024, at 4.044% and assume that newly issued 5-Year Treasury rates are 3.5% by 12/31/2025. An investor considering these two options will be willing to pay more for the 4.044% bond compared to the newly issued bonds at the prevailing rates of 3.5%. Therefore, the 4.044% 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.

Investors may be tempted by the benefits of high yields offered by money market funds. However, 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 Fund rate decreases, additional price appreciation may result.

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. However, only the nominal value of cash is guaranteed. As an example, a $5.00 paper bill from 1998 is still a $5.00 paper bill today. In 1998, a $5.00 bill could buy one movie theater ticket. Today, $5.00 can on average only buy less than half of one movie theater ticket.[6] Again, consideration of the time horizon is critical. Over short-term periods, cash may be reasonable when compared to inflation. However, over longer terms, cash generally loses to inflation.

The below table reflects the historical, inflation adjusted returns (often referred to as “real returns”) of the S&P 500 and the One-Month US Treasury Bills over various time periods.[7] Notably, since 1926, over a twenty-year time horizon, the inflation adjusted S&P 500 returns exceeded the One-Month US Treasury Bills inflation adjusted returns across all periods.[8] The tables below reflect select high stress market periods, including the stagflation of the 1970’ s, the Dot-com bubble, and the 2008 financial crisis. 

Of the periods presented above, 2008 represented the lowest single year of inflation adjusted returns for the S&P 500 at -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, over a 15-year period (ending 2022), the inflation adjusted returns for the S&P 500 were 6.3% and the inflation adjusted One-Month US Treasury returns were -1.7%. Therefore, even in the worst year of market performance since 1937, the 15-year returns of the S&P 500 exceeded that of cash equivalents. Further, the -1.7% 15-year One Month Treasury return indicates that the real return of this cash equivalent lost value relative to inflation.

Therefore, although cash may feel safer because investors can physically touch and feel it, cash is not a risk-free asset in terms of preserving real value. As demonstrated by the 2008 example, equity markets can experience significant price volatility over any short-term period. However, 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.

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 may have been spooked by the 2008 financial crisis and remained in cash could have earned an inflation adjusted 6.3% 15-year return if they were invested in the S&P 500. Instead, they would have lost -1.7% by remaining on the sidelines. Investment statements do not reflect real returns. Further, they do not reflect the opportunity cost of non-participation. 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 much real.

Conclusion     

Money market funds and other cash equivalents provide great tools for short-term cash flow needs with little to no principal volatility. Every financial plan requires some level of immediate liquidity. Beyond that amount, we believe that continuing to incorporate bonds and equities in a well-balanced portfolio will help investors approach other, more nuanced risks, especially over long-time horizons. 


Past performance is no guarantee of future results.  

*US Consumer Price Index (CPI) measures the overall change in consumer prices based on a representative basket of goods or services over time.  Data source for CPI and One-Month US Treasuries: © 2023 and earlier, Morningstar. All rights reserved. Underlying data provided by Ibbotson Associates via Morningstar Direct.  S&P 500 Index: S&P data©2023 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved.

[1] It is possible to lose the principal balance of a money market fund. Although the intention is to maintain a value of $1/ share, no guarantees are provided. When a money market price per share dips below $1, it is referred to as “breaking the buck.” Money market funds have “broken the buck” only twice throughout financial history, and the SEC has increased associated regulations as a result.
[2] Fundresearch.fidelity.com
[3] CNBC.com
[4] https://www.forbes.com/advisor/investing/fed-funds-rate-history/
[5] https://www.cnbc.com/2023/12/13/fed-interest-rate-decision-december-2023.html
[6] https://www.the-numbers.com/market/
[7] Dimensional Funds Matrix Book 2023 – Historical Returns Data
[8] Dimensional Funds Matrix Book 2023 – Historical Returns Data