Why cash is comfortable but can be counterproductive

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Why cash is comfortable but can be counterproductive

With the uncertainty and market swings of the past few years, it’s understandable that some investors would seek the safety of cash. On the surface, holding cash means not having to cope with the ups and downs of the stock market due to the pandemic, global conflicts, rising interest rates, the Fed, and more.

However, this is typically only true over the shortest of timespans. Over months, years, and decades, the value of cash is quietly eroded by inflation, and skilled investors including Warren Buffet are worried about inflation’s effect on the overall economy. For long-term investors, managing behavior and emotions is just as important as managing portfolios. Doing so can help investors stay on track to achieve their financial goals, while helping them to sleep well at night too.

Inflation eats away at value

There are two main problems with sitting on cash today. First, high inflation — the worst in four decades — is eroding the value of cash, especially when it sits in a regular checking or savings account. By not earning a sufficient level of interest or generating a return, the purchasing power of one’s hard-earned money falls each year. According to the latest Consumer Price Index figures released on April 12, 2022, energy costs have increased more than 32% over the past year, food prices 8.8%, the cost of shelter 5%, medical care services 2.9%, and so on. 

Chart: the yields on traditional bond sectors (shown here based on their lowest possible levels) have increased, in many cases above their historical averages.

Chart, bar chart

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Sources: Clearnomics, Bloomberg

This is the hidden cost when investors seek the safety of cash. The balance on a bank statement may feel safe since it is stable, unlike the fluctuating value in an investment account. However, what matters isn’t the dollar amount of cash but what it can purchase. Inflation means that the same number of dollars buys fewer goods and services each year, even when the number remains the same. Thus, the growth of assets is needed to keep an investor’s purchasing power at par.

Rising bond yields attract cash

The second problem is that cash and savings accounts still typically generate little to no income, even with medium and long-term interest rates rising. As of March, the national rate for a 12-month CD was still only 0.14%.  In other words, locking up $1,000 of cash for 12 months would only yield $1.40 when inflation would have eroded its spending power by $80, based on the Consumer Price Index. In this example, the real inflation-adjusted rate is what matters.

The picture is very different for certain other sectors of the bond market. The yields on Treasuries, mortgage-backed securities, and corporate bonds are now above their historical averages. Investment-grade bonds, for instance, now generate 4% per year compared to their average of 3.4% since 2009. Any investment can lose value so past performance does not guarantee future results. 

Ultimately, cash is an important part of any portfolio if used appropriately and in moderation. Having the discipline to save enough cash is the first step toward financial freedom. Investing that cash in the right portfolio can help be what grows savings into real wealth.

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