In the current financial landscape, cash equivalents such as short-term treasury bills, CDs, and select money market funds are offering yields around 5% annually. This enticing prospect has led many investors to feel secure in parking more of their assets in cash instruments for what seems like a “risk-free” return.
While it’s prudent to maintain some cash reserves for various reasons, it’s essential to recognize that historically, cash has not proven to be an attractive long-term investment compared to bonds or stocks.
Even with a current yield of around 5% (annualized), the income generated by cash holdings is typically taxable for individuals. For those in higher tax brackets, this can significantly diminish the after-tax return. Additionally, current yields do not incorporate inflation, which, as of January 2024, is hovering around 3.1% according to CPI data from the past 12 months. Inflation gradually erodes purchasing power, highlighting the famous adage, “A dollar today is worth more than a dollar tomorrow.” When factoring in after-tax, inflation-adjusted returns, the real yield on cash is likely closer to 2% or less.
Furthermore, the very factors that have driven cash yields higher—such as aggressive rate hikes by the Federal Reserve—are also the same ones that will eventually lead yields lower. Indeed, the Federal Reserve indicated in January that they have begun discussions on when it will be appropriate to start lowering short-term rates, and expectations are that this will commence later this year. This will directly impact future returns on cash-equivalent yields.
Lastly, holding excess cash on the sidelines can create missed opportunities to earn potentially higher returns through other types of investments such as bonds and stocks.
As interest rates normalize and the economy maintains stability, reallocating some cash into certain types of fixed income securities for example, may enhance long-term investment outcomes over pure cash.
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