Interest Rates Are High. But Should I Still Hold Cash in My Portfolio?
Regardless of the steep interest rates, is it wise to have cash in your investment portfolio?
Given that certain bank certificates of deposit are offering an annual percentage yield (APY) of over 5% and certain savings and money market accounts are also providing returns in the vicinity of that percentage (as of June 2023), it's understandable why investors may feel enticed to allocate a substantial portion of their retirement funds to cash and cash equivalents. However, it's important to exercise caution as these elevated interest rates have the potential to negate your financial gains during retirement.
Are you unsure about how to distribute the assets in your portfolio based on your objectives? Have a conversation with a financial consultant now.
Potential Dangers of Hoarding Money in Physical Form When individuals opt to hold a significant sum of cash on hand instead of investing it or placing it in a bank account, they expose themselves to a multitude of risks. It is important to be aware of these potential hazards, as they may impact one's financial stability and security. Firstly, one must acknowledge the threat of theft. Keeping large amounts of cash at home is an attractive target for burglars, putting one's hard-earned money at risk of being stolen. Additionally, if the cash is lost or destroyed due to natural disasters or accidents like fire or floods, the financial loss can be devastating. Secondly, the value of cash is subject to inflation. Over time, the purchasing power of money decreases due to factors such as economic fluctuations or government policies. This means that holding cash for an extended period may result in a loss of wealth, as its value diminishes over time. Furthermore, cash savings offer limited opportunities for growth. Unlike investment options such as stocks, bonds, or real estate, cash does not generate any returns. By solely relying on cash, individuals miss out on potential opportunities to increase their wealth through interest or dividends. Lastly, holding a large amount of cash can be a barrier to financial transparency. Without a paper trail or documentation of transactions, it becomes difficult to prove the legitimacy of one's funds. This may pose challenges when dealing with financial institutions or government agencies that require thorough verification of income and assets. In conclusion, while it may seem convenient to keep a stash of cash readily available, it is crucial to consider the risks associated with such a decision. The potential dangers of theft, loss of value due to inflation, limited growth opportunities, and lack of financial transparency highlight the importance of carefully assessing one's financial strategy and exploring alternative options for managing and growing wealth.
According to Amy Arnott, a certified financial analyst (CFA) and portfolio strategist for Morningstar Research Services, it can be logical to hold a substantial amount of money in order to fulfill your short-term goals for retirement income over a period of one or two years. However, beyond that timeframe, it is important to note that having a large amount of cash can have negative consequences for long-term investment objectives like retirement.
Arnott provides an illustration to emphasise his point: "Consider a pensioner who commenced saving $10,000 annually in 1993 and allocated the entire amount to cash. By the conclusion of 2022, their total sum would have reached roughly $380,000. In contrast, had they invested those savings either in a completely equity-based portfolio or a well-balanced fund, they would have accumulated approximately $1.5 million or $1 million, respectively."
There is a caution to be had when dealing with cash accounts that offer higher interest rates due to the fact that these rates have a tendency to increase during periods of inflation. In the present scenario, the Federal Reserve's action of raising rates on ten separate occasions over the span of sixteen months was aimed at controlling the rise of inflation. It is worth noting that the Fed's benchmark federal funds rate had risen from 0.25% in early 2022 to 5.25% by May 2023, while the annual inflation rate stood at 8.54% when the Fed first took action.
As the inflation rate has decreased to around 4%, individuals who deposit money in high-interest accounts at banks can now earn a small amount of profit. However, this favorable situation is not expected to last for an extended period of time. Furthermore, the interest rates offered by banks usually follow those set by the Federal Reserve and have consistently remained lower during the post-pandemic period. Consequently, any substantial gains achieved after accounting for inflation will likely be temporary at best. As inflation declines, the interest rates for one-year certificates of deposit (CDs) are now higher than those for five-year CDs. This suggests that bankers anticipate the Federal Reserve to temporarily pause or even lower rates in response to the decreasing cost of living.
Advantages of Keeping Money in Cash In an era where digital transactions and virtual wallets are gaining popularity, it is essential to recognize the benefits of holding physical cash. Here are several reasons why having cash on hand is still advantageous: 1. Flexibility: Physical currency provides flexibility, especially in situations where electronic payment options may be limited or unavailable. In remote areas or during emergencies, cash allows individuals to make transactions without being dependent on technology or banking systems. 2. Privacy: Cash transactions offer a level of anonymity that digital transactions simply cannot provide. With cash, individuals have the freedom to carry out purchases or payments without leaving a digital footprint, maintaining their privacy and protecting their personal information. 3. Avoiding Fees: Cash payments eliminate transaction fees commonly associated with online or card-based payments. By using physical money, individuals can avoid additional costs imposed by banks or financial institutions, which can often accumulate and become burdensome. 4. Budgeting and Money Management: Using cash can be a helpful tool for budgeting and managing personal finances effectively. With tangible money, individuals have a visual representation of their spending habits, allowing for better tracking and control of expenses. 5. Instant Accessibility: Unlike electronic funds, cash is always readily accessible. When unforeseen circumstances arise or when electronic payment systems are inaccessible, having cash provides immediate access to funds, ensuring individuals can meet their daily needs without interruption. Although digital payment methods have revolutionized the financial landscape, cash remains a valuable asset. By keeping cash on hand, individuals can enjoy the advantages of flexibility, privacy, cost-saving, efficient budgeting, and instant accessibility to funds. Thus, it is important not to overlook the benefits that physical currency can offer in today's increasingly digital world.
Despite the presence of high interest rates, should you continue to include cash in your investment portfolio?
Financial advisors often recommend investing in the stock market because simply holding onto cash is unlikely to outpace long-term inflation. Throughout history, stocks have consistently shown the ability to provide returns after accounting for inflation over extended periods. As interest rates decrease, cash may regain its status as one of the less favored asset types for the purpose of storing funds temporarily or for short-term needs. Nevertheless, having cash accounts is beneficial in certain situations, such as:
No matter if you plan on budgeting for at least three months or a year or beyond, having an emergency fund that is secure and easily accessible is crucial. Frequently, certificates of deposit, savings accounts, and money market accounts serve as great options for this necessity.
In the retirement investing strategy called the bucket approach, individuals divide their assets into three buckets based on the time they will need the money: long-term, medium-term, and short-term. By having one to two years' worth of living expenses in cash, retirees protect themselves from sudden market changes and can endure periods of stock market instability. This approach also reduces the risk of experiencing significant portfolio losses due to poor market performance right at the beginning of retirement, which could make it challenging to sustain future withdrawals for retirement expenses.
Putting money in stocks when it's meant for purchasing a house, covering wedding expenses, or paying for college fees in the near future is not a wise move. This is especially important to consider as there is a possibility of a market downturn which could result in insufficient funds from stocks.
Purchasing the Luxury of Contemplation
A sudden windfall like an inheritance, winning the lottery, receiving an unforeseen bonus, or any other unexpected sum of money can be safely stored in a bank certificate of deposit (CD) or a money market account that is insured by the Federal Deposit Insurance Corporation (FDIC). This generates a small amount of interest, allowing the recipient ample time to ponder and make informed decisions on how they want to invest or utilize their newfound wealth.
Investors who require a portion of their assets in liquid form should take advantage of the temporarily elevated rates offered by bank certificates of deposit (CDs) and money market accounts. However, it is crucial to bear in mind that cash, being an investment, is solely meant to fulfill anticipated short-term requirements.
Determining the appropriate allocation of cash, bonds, and stocks in your investment portfolio is a complex task that evolves significantly as you transition from working years to retirement. Securing the guidance of a financial advisor can provide clarity on how to structure your investments. The process of finding a reputable financial advisor doesn't have to be challenging. With SmartAsset's complimentary tool, you can be connected with up to three verified financial advisors who serve your local area. Moreover, you have the opportunity to engage in an introductory call with each advisor match, allowing you to assess which one aligns best with your preferences. If you're prepared to discover an advisor capable of helping you attain your financial objectives, take the first step now.
Fidelity advises individuals to accumulate savings equivalent to 10 times their yearly earnings by the time they turn 67 in order to prepare for retirement. To determine if you're making progress towards this goal, you can utilize SmartAsset's retirement calculator. This tool will provide an estimate of the amount you can expect to have accumulated by the time you retire.
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The article "Should You Keep Cash in Your Investment Portfolio, Despite the High Interest Rates?" was recently published on the SmartAsset Blog.
