In recent months, some investors have flocked to cash to find safety from historic stock market losses, raging inflation and The Federal Reserve’s rush to raise interest rates. In fact, JPMorgan Chase & Co. strategist Nikolaos Panigirtzoglou estimated that cash levels are close to 40% as of June 2022, the highest level in a decade.
Traditional wisdom says if you want to preserve your money, keep it as cash. This level of caution can help reduce short-term volatility or loss of capital.
But cash is not a growth asset. And it’s not risk-free, either.
While cash has its place in any financial plan, how much cash you choose to hold is unique to your investing goals and individual circumstances. As always, we recommend that you consult with a professional before making financial decisions.
The Argument for Holding Cash
When it comes to financial security, it’s comforting to know that you have adequate cash reserves to tap into when you need it. Many people learned this lesson during the COVID pandemic, when having an emergency fund was essential for minimizing or avoiding financial pain.
Aside from funds for your regular bills and discretionary spending, personal finance experts recommend having three to six months of living expenses in cash in case of an emergency.
In holding a suitable amount of cash in an emergency fund, investors are less likely to withdraw money from elsewhere – protecting the timing on their investments, leaving the long- and intermediate-term holdings in place, and covering short-term spending needs despite suffering low returns on the money.
That’s not to say that money should be stacked in shoe boxes or tucked away in a safe. Cash reserves are best kept in high-yield savings accounts, which typically pay 20 to 25 times the national average of a standard savings account. Right now, the average high-yield savings account pays a 0.1 percent annual percentage yield (APY), but as the U.S. central bank continues its rate-hiking cycle, these yields will likely continue to rise.
There are other options, too, such as one-year Certificates of Deposits (CDs) and Series I Savings Bonds (I bonds). Currently, one-year CDs are averaging 1.5% and top-yielding CD rates pay over 2%, which is higher than a high-yield savings account. I bonds, on the other hand, will pay a 9.62% annual rate through October – although there are purchase limits and you can’t tap into the money for at least one year.
The Argument Against Holding Cash
While stockpiling Benjamins may give you comfort, there’s a major downside to it: Large cash reserves can drag down your portfolio’s returns and cause you to fall behind over the long haul.
Cash, which yields zero, loses purchasing power and generates a very low, or even negative, real return when you factor in consumer inflation, which had a year-over-year increase of 9.1% in June, the highest rate in nearly 41 years. Consider the following analysis from UBS:
Someone with a $5 million, all-cash nest egg who has annual expenses of $250,000 that increase 2% per year due to inflation would have only $2.5 million left after drawing down the cash to pay bills. The same portfolio, if invested in stocks, could be expected to rise in value up to $7 million over the same period of time.
Even in the low-inflation environments in much of the developed world, returns on cash have not kept up with consumer price increases. So the value of cash diminishes in real or inflation-adjusted terms over time.
“Cashing out” your investments by trying to time the market can hurt your investments, too. When your money is invested in stocks and the stock market goes down, you feel like you’ve lost money. But you really haven’t, you’ve only incurred a paper loss. However, when you elect to sell your holdings and move to cash, you lock in your losses.
While paper losses aren’t good, investors in the stock market must accept that the stock market rises and falls. Maintaining your position when the market is down gives your portfolio the chance to recoup losses when the market rebounds. This way, you’re not buying high and selling low.
Ultimately, how much cash you should have on hand depends on your financial situation. Having accessible cash for financial emergencies can help keep your financial goals on track, but too much cash – or cashing out, in an effort to time the markets – can erase progress.
If you have any questions or need further assistance, our team of financial advisors are here to help. You’re welcome to schedule a complimentary consultation below.