Earning interest on cash savings is back in fashion again. After being starved for yield for more than a decade, investors are flocking to money market funds, CDs, and short-term Treasury bills that are paying interest rates above 5% today. Cash yields are even more impressive when compared to inflation; after subtracting the annual rate of change in the consumer price index, “real” rates on cash are close to 2%, well above historical averages. The one-month Treasury bill yield is a good proxy for cash rates, and you can see how much these rates have risen since 2021 in the chart below:

For many investors, these attractive yields are creating a powerful temptation to overweight cash in their portfolios. Cash feels like a warm, cozy blanket on a cold winter night – providing comfort and security against uncertain times and volatile markets. Given how unsteady markets and the economy feel at the moment, does it make sense to reduce stock exposure and load up on cash?

To help us answer this question, we should think in terms of goals – as in, what are we investing for? If we are saving for a house down payment or planning to buy a new car in a few months, then cash is a great choice to help you reach these short-term goals. Cash is safe, highly liquid, and unaffected by stock market volatility. Cash is also a great vehicle for emergency savings, precisely because you don’t want to risk your ability to cover an unexpected bill on volatile stock market returns.

But many financial goals are much further in the future, and cash is unlikely to be the best choice for these kinds of goals for several reasons:

First, as enticing as 5% yields are today, they may last only a few more months. Rates can fall as quickly as they rise, and the market already expects the Federal Reserve to begin lowering short-term interest rates as soon as March of next year. If they do, rates on money market funds and CDs will decline almost immediately. Bonds can offer a little more protection against falling rates; for example, you can “lock in” an interest rate of 5.4% today on a six-month Treasury bill, 5.1% for one year, or 4.7% for two years. Cash, however, offers no rate guarantee from one day to the next.

Secondly, as evidence-based investors, we know that risk and return are related. Since cash is essentially risk-free, long-term returns for cash have been rather low historically; lower than bonds, and much lower when compared to stocks. Bonds have outperformed cash by about 1.3% per year since 1928 (a small difference that has compounded to over 4,800% over that period!). But the highest premiums have been from investing in the stock market – stocks have outperformed cash by 6.3% per year, on average, since 1928. While $1 invested in cash has grown to $20 over the past 95 years, $1 invested in US stocks is now worth $6,244.

And finally, the differences in returns between stocks, bonds, and cash are especially stark in light of inflation. While cash has barely kept up with inflation since 1928, stocks have provided a “real” (inflation-adjusted) return of more than 6.6%. Recall that in order to build wealth, a portfolio must maintain and grow your purchasing power over time. Because stock returns have exceeded inflation so significantly, a healthy allocation to stocks is usually necessary to achieve long-term financial goals like retiring comfortably, especially if that goal is decades in the future.

This is not to say that cash doesn’t have an important role to play in most portfolios; it does, and today’s higher rates make it easier to hold than it has been in a long time. But cash is not meant to be the driver of returns in a diversified portfolio. Earning money market rates north of 5% feels great, especially compared to 0.25% not that long ago. But there is a risk that today’s attractive cash yields will lure us into being too conservative with our investments. So far, 2023 has borne this out. Despite high cash rates, cash has underperformed most areas of the stock market this year. US large stocks are up more than 21% year-to-date, US small stocks have returned 8.3%, and foreign large stocks are up 13.5%.

Long-term successful investing involves risk and definitely some discomfort at times. So, enjoy these unusually high yields on your cash while you can, but at the same time, realize they are probably not a reason to make radical changes to your asset allocation.

Sources: https://ycharts.com/

https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html