Cash is King. Or Is It?

In today's low-interest-rate environment, investors should be wary of holding too much cash.

Cash is an important component of any portfolio and, therefore, any financial plan. Cash is needed to cover day-to-day expenses and for the purpose of paying for short-term liabilities. It also can play a part in your long-term investment portfolio, serving as an anchor during volatile times and giving you the flexibility to make investments during periods of market dislocations.

Yet, in today’s ultra-low interest rate environment, holding too much cash can prove costly. Currently, cash offers no yield and can actually be a drag on portfolio returns. Let’s take a look at the dangers of holding too much cash, how to determine the right amount of cash for your situation and options to put that cash to work.

The Danger in Holding Too Much Cash

With interest rates so low, it is hard to earn a yield on cash that beats inflation. Over the past 20 years, we’ve seen extended stretches during which the return on cash has been below the rate of inflation and we are currently in one of those periods. Since the beginning of the COVID-19 pandemic, the Federal Reserve has pushed short-term rates to near zero and has confirmed its commitment to keeping rates low for the foreseeable future.

While investors may be content earning a low rate for the peace of mind of having cash on hand, it’s important to consider the impact that inflation could have on future spending. Inflation is the rate that goods and services appreciate over time. Exhibit 1 illustrates the relationship between 3-month U.S. Treasury bills and the Consumer Price Index (a measure of inflation) over time. With 3-month Treasury bills currently yielding 0.11% and core inflation at 1.6%, the return on your cash won’t be able to keep up with inflation, meaning your purchasing power will go down and it will be more difficult for you to achieve your goals. For example, assuming the current cash equivalent rate (using the yield on the 3-month Treasury bill) and inflation were the same over time, a $1 million in cash would grow to just $1,022,231 by year 20.  But, that’s before factoring in a modest inflation rate of 1.6%. The future value of your investment would be $740,638 in today’s dollars – roughly 70% of its current value.

Exhibit 1: Impact of Inflation

The other risk is opportunity cost, or missing out on potentially earning a more competitive return in other asset classes. The current rates on money markets dwarf in comparison to stocks and bonds. As returns on cash investments decrease, the opportunity cost of holding cash increases. Exhibit 2 looks at the impact of holding different levels of cash in a portfolio earning different yields. For an investor with $10 million in a 60/40 portfolio, the targeted return is 4.1%. Taking a 10% position in cash, versus allocating just 1%, earning .25% on their cash, we would see the portfolio’s growth reduced by $492,000 over 10 yrs. In that same scenario if the yield on cash were at 2% that impact would be reduced to $272,000. Thus, the decision to hold too much cash can have a meaningful impact on growth of an investor’s wealth over time.

Exhibit 2: Opportunity Cost of Handling Cash

How Much Cash is Enough?

Before determining how much cash is right for you, it’s helpful to think about when and how you will use cash. We consider cash and cash alternatives in three distinct tiers: liquid cash, short-term cash and opportunistic cash.

Liquid cash is the money needed to cover short-term living expenses.

Short-term cash is used to plan for near-term liabilities such tuition payment, funding retirement income or a tax payment, as well as payment for unexpected bills that may arise.

Opportunistic cash is considered part of a long-term investment portfolio, cash can provide an anchor limit losses during volatile periods or the flexibility to make timely investments amid market dislocations.

Determine the Appropriate Cash Balance

A good rule of thumb is to keep enough cash on hand to cover a year to two years of your expenses — investors may consider an additional three months for potential emergencies or other needs. This typically means having enough cash to meet discretionary spending needs as well as the unplanned expenses. In doing so, you avoid disrupting your long-term investment plan, especially during unfavorable market conditions. A guideline we use as a starting point is 3% to 6% of a client’s net worth based on an annual spending need of 3%.

But with that as a guideline, it is important to emphasize that arriving at a single recommendation for cash holdings needs to be personalized. Through our goals-based approach, we take time to understand your lifestyle needs, including day-to-day living expenses, an emergency fund and a reserve for investment opportunities. With your cash needs defined, we’ll look at your cash flow and line up assets and liabilities to determine what portion is needed to meet these shorter-term expenses and the timing of each. Spending requirements, risk aversion, age to retirement and other factors will influence how much cash each investor holds at any given time.

We use proprietary technology to demonstrate how small changes in your spending and lifestyle choices can impact your long-term wealth. By modeling thousands of outcomes, we can provide a comprehensive look at your potential future financial situation, allowing you to better weigh your options and make smarter, more informed decisions.

A Broad Array of Solutions to Meet Your Cash Needs

From bank deposits, to money market funds to short-term bond funds, there are a range of solutions that could fulfill your cash needs. Each solution offers a different combination of time horizon, yield and risk considerations as illustrated in Exhibit 3.

For example, cash that is needed to meet daily expenses or immediate needs should be very liquid and guaranteed in bank deposit accounts, such as checking, savings or certificates of deposit. If there is greater flexibility on the timing of when you need cash, you can give up some of the liquidity for a higher, more competitive yield. Enhanced cash accounts and short-term bonds don’t provide principal protection like bank deposits, but have limited risk and can offer additional yield. For cash that is set aside as part of a longer-term investment plan, a short-term fixed income investment can provide the combination of enhanced return and accessibility needed to make timely investments during periods of market volatility.  In this low return environment, investors may also want to consider using a line of credit, secured by their investment portfolio, to meet cash flow needs and maintain investment objectives.

Exhibit 3:

A Trusted Partner

In today's low-interest-rate environment, all investors should evaluate their short-term cash needs within their total wealth plan. This should help ensure you have right balance between being able to meet all of your short-term cash needs, while minimizing the drag on your portfolio's long-term performance and using low rates to your advantage.

At BNY Mellon Wealth Management, you will have access to advice and guidance from a team of professionals with expertise across all wealth management disciplines from investment management, private banking and wealth planning. We’ll work with you to customize a plan that is optimized for your cash flows needs as well as your longer-term wealth objectives. As a result, you’ll have the peace of mind you get from knowing you'll be able to handle whatever expenses might crop up in the near term and that your cash investments are protected by the safety and security of one of the highest rated banks.

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