Following the post-COVID stimulus hangover in 2022, the bull market has continued to run. One of the key factors was the Federal Reserve’s decision to
Reinvesting Cash on the Sidelines
Published Date : July 20, 2023
July 20, 2023
It is human nature to want to avoid loss and instead seek refuge in something that feels safe. After the very pronounced and painful market declines of last year, a new wave of participant risk aversion flooded markets as investors piled a record amount into money market funds, where $5.4 trillion of it remains as of early July. The fresh appeal, due to steep Fed rate increases in 2022, of about 5% return on the typical current risk-free cash asset is something that investors have not seen in decades, and it is certainly a welcome change for anyone with a short-term time horizon. However, for long-term investors who need equity-like returns to achieve future goals, holding excess cash today still poses risks.
The following three questions can help reveal some of the biggest risks associated with excess cash:
What’s the real return on cash? The real return on cash (the stated yield minus inflation) is currently around 1% based on CPI data released in June, and it has actually averaged 0.9% over the past 40 years; but it dipped to a negative real rate of 1.2% over the past 20 years, and negative 1.6% over the past 10 years. In essence, inflation makes it very difficult for cash to maintain its purchasing power over time. For investors focused on wealth accumulation or for those who need to sustain a withdrawal rate, nominal cash returns are still simply too low.
What’s my reinvestment risk? Reinvestment risk is the possibility that interest rates will decline, and hence future funds will have to be reinvested at lower rates. Although we may get one or two more rate hikes this year, as of June, the Fed is forecasting that interest rates will decline to 2.5% in three years. One way to mitigate reinvestment risk is to match the investment’s maturity with your time horizon. For bond investors who went to cash during last year’s difficult period, historically, at this point in the cycle, investing cash back into bonds has provided a meaningful return advantage.
What’s my opportunity cost? This is always easier to evaluate in hindsight and over longer periods of time. Over shorter periods, it usually involves the risky business of market timing. While cash did outperform both stocks and bonds in 2022, this result is the exception, not the norm. In fact, over the past 40 years, cash has only outperformed both stocks and bonds five times and it has never done so over a rolling 2-year period.
One of the biggest pitfalls with timing a market re-entry from cash is waiting too long to develop a plan. This often happens because the best time to invest is usually when things feel the worst, but when things feel the worst, investors are least likely to act. This year, investors have faced regional bank failures, debt ceiling concerns, more rate hikes, persistent inflation, and constant chatter about a recession on the horizon. And despite these worrisome headlines, the equity market (S&P 500) went on to rally by over 16% during the first half of this year.
I like the quote by Peter Lynch, “Far more money has been lost by investors trying to anticipate corrections, than lost in the corrections themselves.” While the desire to hold cash to avoid a short-term market correction is understandable, the trouble is that in due course it can create more problems than it solves. Cash is often referred to as a “risk-free” asset (in that the nominal value will not decline); however, there are other risks associated with holding too much cash—risks that are still relevant today, even in a world where cash-equivalent money market funds yield 5%.
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