Returns on cash investments haven’t always beaten inflation—that’s typically a role for other investments, such as stocks. However, with inflation still low but rising, cash returns are rising, as well. That might make cash more attractive for investors who have avoided it despite its other advantages.
For years following the credit crisis in 2008, interest rates on cash and cash investments hovered near zero. Then the Federal Reserve began raising short-term interest rates at the end of 2015, leading to higher returns on cash investments, which tend to track short-term interest rates.
Returns on cash investments have risen recently, along with the federal funds rate
Source: Schwab Center for Financial Research. Federal Reserve and rolling 12-month cash investment returns, represented by the Ibbotson 3-Month Treasury Bill index, from 7/1/1954 to 2/28/2018. The shaded area highlights the period when the Federal Reserve was tightening monetary policy by increasing the federal funds rate.
Cash can play a useful role as a portion of your portfolio, in our view, for stability, liquidity and returns that typically rise with interest rates and inflation. It can also provide ballast in markets where other asset classes—stocks and bonds, for example—drop in value at the same time. Beyond investment, cash can play an important role in financial planning, to provide liquidity and support short-term goals.
What is cash?
Many people think of cash as physical currency—bills and coins in circulation. For practical purposes, however, the term “cash investments” also includes traditional bank deposits, such as checking and savings accounts, where you generally have access to your funds on demand and without risk of losing any principal (up to Federal Deposit Insurance Corp, or FDIC, limits¹).
In an investment context, the definition of cash can expand to other types of cash investments, including short-term, relatively safe investment vehicles such as money market funds,² U.S. Treasury bills (T-bills), corporate commercial paper and other short-term securities. Many of these aren’t covered by FDIC insurance, but may be of high credit quality. Most are similar in that they are, or hold, short-term fixed income (i.e. bond) investments.
There are at least three reasons to hold cash or cash investments as part of a financial plan and portfolio.
Reason 1: Liquidity
Apart from day-to-day expenses, the need for liquidity generally falls into two categories:
- Emergencies (health problems, lost job, etc.)
- Known obligations or likely expenses in the next one to three years
For emergencies, consider setting aside an “emergency fund” of cash equal to at least three months’ worth of non-discretionary spending, though the actual amount could vary depending on your situation, job stability and other sources of income and credit.
Then consider setting aside money for known obligations you might pay from savings (instead of current salary or other monthly income). These can include quarterly estimated income taxes, property taxes, a down payment on a home, a child’s wedding, college bills, a vacation and so on. Unlike the emergency reserve, which is intended for the “just in case,” think about cash that’s set aside to cover known obligations as money that’s already spent.
Liquidity is extremely important for these needs—don’t invest money reserved for short-term spending in the stock market. Instead, keep it in cash, cash investments, or shorter-term investments with minimal principal risk between now and when you need to spend the money.
Liquidity for retirees
Retirees typically have special liquidity needs, such as increasing medical costs, and limited or no earned income. The need for an emergency fund may decrease somewhat, as a job loss becomes less of a concern.
However, retirees generally need to rely on their portfolio more heavily to support spending, to have stable investments to make required minimum distributions from retirement accounts, and for other purposes. Consider setting aside enough cash to cover at least 12 months’ living expenses after accounting for other income sources. This balance provides cash to support spending and limits pressure to sell more volatile investments from the portfolio in a down market.
Beyond that, consider investing another two-to-four years’ worth of expenses in short-term investments (short-term bonds, certificates of deposit and so forth) as part of the fixed income portion of your retirement portfolio. That way, during a bear market, you could avoid having to liquidate other assets at the worst possible time.
Reason 2: Flexibility
By holding a portion of your portfolio in cash, you can take advantage of investment opportunities as they arise. A cash allocation may be helpful if you overweight or underweight certain asset classes in your portfolio based on your outlook for the markets.
A cash allocation can provide flexibility when it’s time to rebalance your portfolio or take distributions. You might also use excess cash to buy on dips when markets fall, or replenish your cash cushion when markets rise.
Reason 3: Stability
Bonds have been the traditional choice when seeking to reduce a portfolio’s overall risk. Historically, they have tended to perform differently than stocks in the same market conditions—sometimes moving in the opposite direction.
Historically, cash investments have been even less correlated with stocks. In addition, cash investments are far less volatile than long-term bonds. One advantage of bonds, of course, is potential for higher income. But in an appropriate proportion, cash and cash investments can help stabilize investment performance and deliver positive return over time.
Since 1978, cash investments, as represented by the Citi U.S. 3-Month Treasury Bill index, have delivered higher returns than at least one of the major asset classes—U.S. large cap stocks, U.S. small cap stocks, international developed market stocks, commodities and bonds—in 11 of 39 years. Cash investments were the top performer only once over that period—in 1981, when inflation was high and the Federal Reserve under then-chairman Paul Volcker was hiking short-term interest rates rapidly to tame it. But between 1978 and 2017, full-year returns were never below zero.
In this role, cash investments can be the most reliable of the more defensive asset classes included in your portfolio. Gold and other assets classes used for diversification and defense against risk in stocks can also be highly volatile. Cash returns may be relatively low, relative to potential return in other asset classes, but the value of cash is never very volatile. Don’t take too much risk for a bit of extra return here. Risk is generally best left for the more aggressive portions of a portfolio.
After you’ve set aside money for emergencies and known obligations, consider some cash in your investment portfolio. How much will depend on your time horizon and risk tolerance.
Concerned about low cash rates today?
If you’re worried that your cash and cash investments aren’t providing adequate returns, remember that cash returns are tightly tied to the Federal Reserve’s federal funds rate—the rate banks charge each other for overnight loans—and inflation. As the federal funds rate target rises, as it has done during the past few years, cash returns tend to rise as well.
The chart below illustrates this. The federal funds rate was near zero between 2008 and 2015. But the Fed began raising the rate in December 2015. As of March 2018 it was at 1.75%, with additional rate hikes expected in 2018. In the past, as the Fed has adjusted rates, cash returns have followed closely.
Rates on cash investments historically have tracked the federal funds rate
Source: Schwab Center for Financial Research. Federal Reserve and rolling 12-month cash investment returns, represented by the Ibbotson 3-Month Treasury Bill index, from 7/1/1954 to 2/28/2018. The shaded areas highlight periods when the Federal Reserve was tightening monetary policy by increasing the federal funds rate.
Where can you keep your cash?
Whatever your reasons for holding cash, you need a place to put it.
Consider these options:
- Checking, savings and money market accounts are options for day-to-day expenses as well as the emergency reserve.
- Purchased money market funds, which can be purchased in brokerage accounts. Funds may be available the next business day if shares are sold by 4 p.m. Eastern time, and the funds may have rates higher than those available from bank accounts.
- Shorter-term certificates of deposit (CDs) and T-bills can be used as part of a strategic cash investment allocation and are also useful for known obligations coming due in the next three to 12 months. These investments, with their fixed maturity dates, aren’t as liquid as the alternatives in the first bullet. Ideally, the maturity of the CD or T-bill could match up with that of any known obligation.
- Longer-term CDs can be used as part of a strategic cash investment allocation or for known obligations coming due within one to three years.
* Rule 2a-7 of the Investment Company Act of 1940 mandates that money funds limit their investments to securities with maturities of 397 days or less, that they maintain a weighted average maturity (WAM) of 60 days or less, and that they maintain a weighted average life (WAL) of 120 days or less. Money funds also may only invest in high quality securities—those with the highest short-term ratings—and are subject to minimum diversification and liquidity requirements.
The type of investment, along with how much cash to set aside, is dependent on each investor’s situation and preferences. Whatever the investment vehicle, consider using cash or cash investments to help build toward longer-term objectives.
What to do now
Cash and cash investments play a role in your financial plan, in our view, and can play a useful role in your portfolio. Use it, with other tools, based on your situation and needs, to help achieve your financial objectives.
¹ FDIC insurance covers deposits received at an insured bank, including deposits in a checking account, negotiable order of withdrawal (NOW) account, savings account, money market deposit account, CD, or an official item issued by a bank, such as a cashier’s check or money order. At the time of publication, the standard deposit insurance amount was $250,000 per depositor, per FDIC-insured bank, per ownership category. Examples of products not covered by the FDIC include stock investments, bond investments, mutual funds, life insurance policies, annuities, municipal securities, safe deposit boxes or their contents, and U.S. Treasury bills, bonds or notes.
² An investment in a money market fund is not a bank deposit and is neither insured nor guaranteed by the FDIC or any other governmental agency. Although money market funds seek to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in these funds. Investment value and return will fluctuate such that shares, when redeemed, may be worth more or less than original cost.