The cliché “cash is king” gets tossed around a lot, usually by people holding lots of cash and especially during bear markets, asserts Rich Moroney, editor of Dow Theory Forecasts.
Certainly, it feels better to hold cash when equity and bond markets are slumping. And we all need cash to fund our financial responsibilities. However, is cash really “king” as an asset class? Probably not.
In fact, cash makes for a horrible long-term investment, due to the erosion of spending power, not to mention the opportunity cost of holding cash versus other assets, such as stocks. However, now interest rates are rising and equity markets declining. So, should investors be thinking differently about cash? In short, is cash now a good investment?
The answer is still no. Keep in mind that we see a significant lag between higher rates on things like mortgages versus higher rates on money markets or checking accounts. Cash, while earning more than it did a year ago, still earns very little.
According to Bankrate, a tracker of bank interest rates, most banks still provide rates on deposits well under 1%. Furthermore, when you look at “real” returns (nominal interest rate minus inflation), cash returns are decidedly negative.
In fact, because of soaring inflation, holding cash loses more money for investors than it did when deposit rates were practically zero and inflation was running at 1% to 2%. You should not be thinking about cash as an attractive asset class. It still stinks.
A Tool, not an Asset Class
Cash’s terrible investment potential means investors need to think about cash not so much as an asset class in which you seek to maximize returns — I’ll discuss a few pitfalls of this approach in a minute — but as an opportunity set for investors.
If you view cash as an investment asset, you may seek superior returns via higher yields. However, such an approach can lead to higher risk or restrict the flexibility cash provides.
For example, upset by the near-zero interest rates offered by banks, investors in recent years stretched for yields in bonds or high-yielding stocks — assets carrying significantly higher risk and volatility than cash. Investors also traded flexibility for slightly higher yields by locking up their cash in certificates of deposit, annuities, and other structured products.
Now, is it a mistake to seek higher returns for your cash? It is if you rush to pick up nickels in front of a steamroller, which can happen when you put cash into higher-risk investments or lock it up in some term investment for only marginally higher expected returns.
You probably have a friend who brags about generating an extra 0.5% on his $35,000 in cash by moving to a new financial institution or some structured investment. But consider this — is the additional $175 per year in interest (that’s right, 0.5% on $35,000 is just $175) really worth the hassle?
Bottom line: If you want to chase yield and interest rates with your cash, frame the decision in terms of dollars gained versus hassle and risk to achieve those dollars. My guess is that you may make different decisions, especially if that investment also restricts your liquidity.
Cash Buys Opportunity
From an investment standpoint, the greatest value of cash is the opportunity set it brings investors, not the returns it generates. Cash can help cushion the blow during down markets. More importantly, cash provides ammunition to invest in capital markets when opportunities arise.
If you, like the Forecasts, have raised cash in recent months, don’t get too exotic. The Forecasts has chosen to shelter its cash in the Vanguard Short-Term Corporate Bond Index Fund ETF (VCSH).
This bond fund does carry a higher-level of risk than cash — and higher rates have crimped returns year-to-date — but the Forecasts is comfortable with this level of risk versus the commensurate yield return (roughly 3%) and liquidity.
If you’d prefer even less risk, consider the Vanguard Ultra-Short Bond ETF (VUSB), which contains shorter-term bonds than Vanguard Short-Term Corporate and yields about 2%.
If you want zero volatility, try a money-market account. You will likely earn less than 1%, but with minimal risk. Finally, if you want virtually no risk, consider FDIC-backed accounts at a bank.
