Can cash really be an ‘investment’?
Cash or cash equivalents like money markets or savings accounts are occasionally considered money “not doing anything” for you. And I don’t blame folks for thinking this way, given that yields on cash are essentially 0% to maybe 0.75% (judging by a cursory review of FDIC options via various online banks).
I recently reviewed an analysis report noting that, in April, $4.13 was invested in stocks for every $1 in money markets. Assuming this resource is accurate, this represents one of the highest stock-to-cash ratios in the last 30 years. Clearly, people are getting tired of “earning nothing.”
I think this type of thinking could be a mistake, though. Cash can be viewed as both a “savings” vehicle for short-term goals and an “investment vehicle” as part of a diversified long-term portfolio. Just because cash doesn’t have any (or very little) earnings associated with it right now doesn’t mean it’s “not doing anything” for you.
For the sake of discussion, let’s focus on cash as a long-term component of an investment plan (i.e., a piece of your asset allocation plan consistent with your own goals, objectives, risk tolerance, etc.). Furthermore, I’m in no way making any market-timing calls here or trying to argue to alter any well-designed plans you may have. I’m simply looking to shed some light on what, these days, is a rather unloved asset and then let you decide.
For starters, cash (assuming it’s FDIC-insured) always does two critical things in a long-term portfolio, no matter what environment we’re in:
1. It is one of the only asset classes that can handle a shock to the markets, such as occurred during the crisis of 2007-09. Crises are rare, but when they happen, they are shocking, and so shock-absorbent asset classes, even in small doses, can add value to a long-term portfolio by cushioning equity and credit downsides. However, because crises are rare, having too much in a shock-absorbent asset may be inappropriate for a long-term investment portfolio. Balance seems sensible here.
2. More commonly, cash allows you to efficiently redeploy capital, whether that means dollar-cost-averaging your cash into stocks, bonds, etc., during your accumulation years or using it for distribution needs in retirement (usually through dividends, interest, principal, and/or capital gains distributions). Without having some cash around, it’s possible the tax impact of reinvesting or distributing funds could be unnecessarily negative.
3. Another attribute of cash today — given that yields are low not just for cash but essentially all bond instruments — is that cash can actually offer a compelling cushion in your portfolios as a hedge against possible interest-rate risks. In a very low-yielding interest-rate environment, increases in interest rates have a much larger impact on bonds than in a higher-yielding environment (all else being equal).
A good example of this would be comparing money-market cash — assuming a yield of 0.50% (you can actually find a higher yield than this at various online-bank money markets) — to that of a short-term bond index fund.
A good low-cost, short-term bond index today is yielding about 1.15%. In this example, that’s a yield “spread” of 0.65%. Well, that’s a lot better than 0.5%, right? That depends. The bond index has a duration of about 2.7 years. The money market (cash) has essentially no duration.
What does duration have to do with it? Duration is essentially the blended term-structure of your bond holdings. In a bond index, that means hundreds to thousands of positions with roughly an average term of 2.7 years. Duration is a critical factor to monitor because it allows an investor to understand the impact of interest rates rising or falling. All else being equal, if interest rates rise by 1%, the short-term bond index loses about 2.7% of its value. (And vice versa. This is not exactly the calculation, but it’s very close.)
The money market fund loses no value, and it should immediately (or shortly thereafter) see an increase in yields. The short-term bond index will also eventually see an increase in yields, but at a much slower pace because it has about a three-year holding period for the bonds. Further, the short-term bond index that was previously yielding 1.15% may need more than two years to break even (assuming again that all else is equal and there’s no change in interest rates).
The point is not to say that one is better than the other, or to encourage market timing, but rather to explore what makes holding cash a reasonable alternative to, say, holding short-term bonds or other “higher-yielding instruments.” It’s likely that both have a place in a long-term portfolio. In essence, cash, even though it does little if anything in terms of yield, does offer something:
1. It cushions equity and credit risk, especially in times of crises.
2. It allows you to efficiently distribute funds and reinvest funds, or if you’re an active market-timing investor (which I don’t recommend), it allows you to buy more when you perceive markets to be cheap versus expensive.
3. It would cushion term risk if rates were to rise.
Cash is worthy of some love and can have a place in a well-designed, long-term portfolio, and if it’s deployed reasonably, it adds a lot more value than “not doing anything.”
Michael Dubis is a fee-only certified financial planner and president of Michael A. Dubis Financial Planning, LLC. He is also an adjunct lecturer at the University of Wisconsin Business School James A. Graaskamp Center for Real Estate. Mike can be reached at email@example.com. This article contains the opinions of the author. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products or services described in this website or that of the author’s. Mike Dubis does not guarantee the relevancy, appropriateness, or accuracy of any outside information or links. Mike Dubis does not render or offer to render personalized investment advice or financial planning advice through this medium. All references that might be made to an investment or portfolio's performance are based on historical data and one should not assume that this performance will continue in the future. THIS COMMUNICIATION MAY NOT BE USED BY YOU AS A RELIANCE OPINION WITH RESPECT TO ANY FEDERAL TAX ISSUE DISCUSSED HEREIN AND IS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED, BY YOU FOR THE PURPOSE OF AVOIDING PENALTIES THAT MAY BE IMPOSED ON YOU BY THE INTERNAL REVENUE SERVICE.
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