The Role of Cash in a Portfolio

The baseball player Yogi Berra once said that “a nickel ain’t worth a dime anymore.” With inflation remaining above historical averages in recent years, many investors may feel similarly. While everyday expenses have increased alongside higher prices, short-term interest rates have also declined from recent highs.

As a result, investors holding significant amounts of cash may find that the purchasing power of those assets declines over time as inflation outpaces cash yields. With money market fund assets near record highs at $7.9 trillion, some investors may be holding more cash than is necessary to meet their short-term needs or overall financial objectives.¹ Understanding the role of cash within a broader financial plan can help investors make informed decisions.

Managing cash requires careful planning

Cash serves an important role in financial planning because it provides liquidity, stability, and funds for near-term expenses. At the same time, holding more cash than necessary may reduce long-term growth potential. While cash is generally less volatile than stocks or bonds, it may not provide the same opportunity for long-term appreciation or income.

From an investment perspective, “cash” often refers to liquid, short-term holdings such as savings accounts, money market funds, certificates of deposit (CDs), and similar vehicles. These assets can play an important role in building emergency savings, funding upcoming purchases, covering living expenses, or preparing for other short-term financial goals.

Rather than asking whether to hold cash, investors may benefit from evaluating how much cash is appropriate based on their goals, investment time horizon, liquidity needs, and risk tolerance. Holding cash beyond those needs may reduce the portion of a portfolio invested in assets with greater long-term return potential.

As the accompanying chart illustrates, money market fund assets remain near record levels after increasing during the period of higher interest rates. While higher short-term yields attracted many investors, these rates can change as monetary policy and market conditions evolve. Because cash investments typically mature over relatively short periods, investors may face reinvestment risk if future interest rates are lower than current rates.

This consideration may be especially relevant today as short-term interest rates have declined from recent highs. Investors who increased cash allocations during this period may have experienced declining yields while participating less in gains from other asset classes.

Inflation can reduce purchasing power over time

Although cash balances generally do not fluctuate in value like stocks or bonds, inflation can reduce their purchasing power over time. Even modest inflation may have a meaningful cumulative impact over many years unless investment returns help offset rising prices.

As the accompanying chart shows, inflation-adjusted returns on cash, measured using current CD rates published by the FDIC, have been negative during many periods over the past two decades.² In other words, inflation has often exceeded the interest earned on cash investments. At the time of writing, headline inflation is approximately 4.2% while the one-month Treasury yield is approximately 3.7%, illustrating that real cash yields may remain negative under current conditions.³

Savings accounts, money market funds, and short-term CDs also require reinvestment as they mature. Future yields depend on prevailing market conditions and may be lower than those previously earned.

Stocks and bonds may help support long-term objectives

Stocks and bonds have historically served as the primary building blocks of diversified investment portfolios because they may provide opportunities for long-term growth and income, although both are subject to market risk.

Dividend-paying stocks may provide income in addition to the potential for capital appreciation. However, dividends are not guaranteed and may be reduced or eliminated at any time. Certain sectors of the S&P 500, including Real Estate, Energy, and Utilities, currently offer dividend yields above 3%, although sector performance and dividend payments can vary over time.

Similarly, extending the maturity of bond investments may provide higher yields than shorter-term cash investments, although doing so generally involves greater interest rate risk. At the time of writing, the 2-year Treasury yield is approximately 4.2%. Investment-grade corporate bonds yield approximately 5.3% on average, compared with a historical average of approximately 3.9%, while the Bloomberg U.S. Aggregate Bond Index yields approximately 4.8%. Unlike cash, bond prices may fluctuate in value as interest rates and market conditions change.

Historically, diversified portfolios that include stocks and bonds have provided greater long-term return potential than cash alone. However, all investments involve risk, and there is no guarantee that any investment strategy will achieve its objectives or outperform cash over any specific period.

The bottom line

Cash remains an important component of a well-designed financial plan by providing liquidity for emergencies and short-term financial needs. However, maintaining cash balances that exceed those needs may reduce long-term purchasing power and investment growth potential.

Investors may benefit from periodically reviewing their cash allocations with a financial professional to determine whether they remain appropriate for their financial goals, investment time horizon, and risk tolerance. A diversified investment strategy may help support long-term objectives, although diversification does not ensure a profit or protect against loss in declining markets.

Disclosure

Past performance does not guarantee future results. All investing involves risk, including the possible loss of principal. Diversification does not ensure a profit or protect against loss. Bond prices generally move inversely with changes in interest rates, and bond investments are subject to interest rate, credit, and inflation risk. Dividend payments are not guaranteed and may be reduced or eliminated at any time. Investors should consult with their financial professional before making investment decisions.