“Cash is king.”
But is it a great investment?
Historically, investors have built up dry powder to fund emergencies or survive market downturns.
But with cash now yielding 5%, many investors are viewing cash as a way to make money.
Today I’m sharing why cash — even at today’s rates — is a bad investment. I’m also sharing how much cash a retirement investor should consider holding.
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- Nominal Returns vs. Real Returns
- Cash is King
- Historical Returns
- May 2023 Inflation Report
- Vanguard Treasury Money Market Fund (VUSXX)
- Should Retirement Savers Own Bonds?
- How to Boost Your Return On Cash
Why Cash Is Not a Great Investment (Even With a 5% Yield!)
Taylor Schulte: Cash is king.
The origin of this popular phrase is unknown, but most sources give credit to the CEO of Volvo who allegedly used the expression shortly after the global stock market crash of 1987.
He used the phrase to suggest that companies with strong cash reserves were able to weather the recent storm better than others.
Cash was king during that time period. And, similar to large publicly traded businesses, retirement investors often build up cash reserves for protection as well. Like Volvo in the late ’80s, cash can help retirees weather unpredictable, catastrophic storms.
However, with money markets, high-yield savings accounts, and bank CDs currently paying 4-5% interest rates, many are viewing cash as an investment. They are viewing cash as a way to make money, not necessarily as a way to protect their financial plan against a prolonged downturn in the markets.
Welcome to the Stay Wealthy podcast, I’m your host Taylor Schulte, and today I’m sharing why cash is a bad investment, even at today’s interest rate levels.
To grab the links and resources for today’s episode, just head over to youstaywealthy.com/189.
When evaluating investment returns, there are many different metrics we can use to measure the performance or outcome.
The two that most investors are typically concerned with are nominal returns and real returns.
The nominal rate of return of an investment is the amount of money made before factoring in taxes, fees, and inflation.
For example, if you invested $100,000 into the S&P 500 one year ago today, and your investment is now worth $110,000, your nominal rate of return was 10%.
Nominal returns are what most investors pay attention to when reviewing their portfolios. By ignoring variables like fees, taxes, and inflation, many investors find it easier to compare the performance of different investments.
Not all that different than comparing your gross salary to another person's gross salary. Two people may have the same $100,000 gross salary, but person A might be in a higher tax bracket than person B due to their geographical location, let’s say, and therefore end up with less money in their pocket on payday.
The real rate of return (often referred to as REAL RETURN), on the other hand, adjusts an investment's nominal return for one important factor – inflation. The real return is the percentage return of an investment after inflation is factored in. It’s an inflation-adjusted return.
And, yes, technically, the real return would also be net of things like fees and taxes, but we’re keeping it simple today and running with the overly simplified definition of real returns that just strips out inflation.
Going back to our prior example of investing $100,000 in the S&P 500 one year ago today…if the nominal return during that time period was 10% and inflation was 6%, the investor's REAL RETURN was 4%. Inflation – i.e., higher prices for goods and services – ate into the investor's nominal return and their purchasing power.
As you might guess, nominal returns will always be higher than real returns, except when inflation is absent or we are experiencing deflation. But in a normal environment, some level of inflation exists. Historically, on average for the last 95 years, around 3%. So if you earn 10% on an investment, about ⅓ of that NOMINAL return gets eaten up by inflation, sometimes more, sometimes less.
Because everyone is running around quoting nominal returns, real returns are often forgotten. I regularly hear people talk about the early 1980s and the interest rates being paid on their cash and tax-free bonds…but then fail to reference the rate of inflation during that time period…or the interest rate they were paying on their mortgage.
I think, psychologically, it just feels better to us to earn a healthy rate of return on our cash, even if our inflation adjusted return is, more or less, in line with historical averages. Especially coming out of a period where cash in the bank paid 0% for what felt like an eternity.
On the surface, earning 5% on our cash certainly feels better than earning 0.1%. But now we know that those nominal return numbers only represent one side of the return equation. And, in reality, 5% and 0.1% nominal returns might be closer than we think when inflation is taken into consideration and we calculate our real returns.
For example, from May of 2022 until May of 2023, the Vanguard Treasury Money Market Fund (VUSXX) – i.e., risk-free cash in the bank – finally paid investors what felt like a healthy return of about 3.4%. But, as the recent May inflation report highlighted, inflation during that 12-month time period was 4%. So, cash investors, while they might have felt like they were finally getting paid to stuff everything under the mattress, were, in fact, losing money to inflation, losing purchasing power.
Not all that different than the frustrating time period from 2009 to 2020 when the average return on cash was about 0.4% – or basically nothing – and inflation averaged around 1.6%. Cash yields were well below historical levels, and so was inflation.
And yes, I’m cherry-picking a few recent time periods here to help make the point that nominal returns don’t tell the whole story. There are time periods like 1978 to 1999 where cash outpaced inflation by about 3% per year, on average. But that is one single unique time period and should not be expected by long-term investors.
And for what it’s worth, during that 21-year span, US stocks outpaced inflation by about 12% per year, on average. So, even though cash had a positive real return, it was a fraction of what the equity market delivered during that time period.
As always, longer time frames should help investors set better expectations with their investments. For the last 95 years, on average, cash under the mattress has returned about 3% – roughly equal to the average rate of inflation during that same time period.
In other words, over long periods of time, investors should not expect cash under the mattress to outpace inflation and increase their purchasing power. And that’s the core reason investors take risk with their hard-earned money and invest it in other asset classes – to earn a rate of return above and beyond inflation.
So, while I believe investors should be smart with their cash and optimize the dollars they do keep under the mattress by leveraging treasury money market funds and/or high-yield savings accounts, I don’t think we should view today’s 5% cash-yielding environment much differently than in years past.
Sure, we might get lucky and catch a short period of time where cash returns outpace inflation or even outperform stocks and bonds, but now we’re hoping that we have a working crystal ball, and personally, I don’t think anyone does.
Investing is a risk/reward decision. If we want to earn healthy REAL returns that allow us to reach our retirement goals and/or enjoy spending money in retirement without putting our plan in jeopardy, we have to accept a certain level of risk.
We also have to be careful viewing cash as an investment. In the accumulation phase of life, investing money in cash is a sure way to reduce the growth rate of your dollars. Go back to that time period from 1978-1999 that I referenced when cash had some of the best real returns in history. Sure, you outpaced inflation by about 3% each year for those 21 years, but the US stock market turned $100,000 into $3.3MM during that same time period.
That was a significant wealth-building opportunity that most long-term savers couldn’t afford to miss.
On the other end of the spectrum, those who are in retirement viewing cash as low-risk investment are increasing the chances of running out of money before end of life. A certain rate of return, above and beyond inflation, is required in order to maintain regular withdrawals and maintain purchasing power over a 40-year retirement.
And I’ve addressed this before, but one response I often hear is that investing in cash right now is a bond replacement. That they don’t think bonds are a good investment at the moment so they would prefer to own cash. The challenge is that cash doesn’t produce the returns a retirement investor might need when catastrophic events hit.
Rewind back to 2008/2009. From October 2007 to the bottom of the market in March of 2009, the US stock market was down about 50%. Meanwhile, cash had a cumulative return of about 3% (not bad) while intermediate US treasury bonds returned 13%. That 13% total return from AAA-rated bonds during the second worst recession in history was wildly helpful to a retiree taking regular withdrawals from their portfolio to fund retirement.
They would have been able to withdraw money from the appreciation in their bonds (or as we call it, their war chest) while their stocks went on a wild ride for 18 months.
Perhaps another catastrophic event is not around the corner. But if inflation continues to tick down, might we see the Fed reverse course and begin lowering interest rates? If that occurs – which seems plausible based on everything we know today – a 3-year bank CD paying us 4% may not look all that appealing compared to the price appreciation that AAA-rated bonds would deliver in that situation.
While I’m comparing these two asset classes in isolation, it’s truly not an either-or situation. For those who are in retirement or nearing retirement, a healthy % of bonds AND cash – despite how each might be performing in the short term – is required in order to maintain healthy withdrawal rates for multiple decades.
As I’ve shared before, our rule of thumb is to establish a war chest of cash and bonds that equals 2-5 years of living expenses. It might equal 2 years if you prefer taking a little more risk (or need to take more risk) and it might equal closer to 5 years if you are risk averse (or your plan doesn’t require more risk because you have over-saved).
Cash is king. And for those who are in retirement or close to it, a healthy cash balance is absolutely needed to weather unpredictable storms, as the Volvo CEO famously stated. But cash is not an investment. Higher yields are great, except when we compare those higher yields to the rate of inflation.
And, more importantly, higher cash yields should not lure long-term retirement investors into thinking that they can outsmart the markets and achieve a higher return with less risk. Risk and return go hand in hand. If we want to have a successful retirement plan if we want to maximize our retirement income while mitigating the chances of running out of money throughout a 40-year retirement, we have to make 40-year investing decisions. Chasing short-term trends, even with an asset class as boring as cash, will only increase our long-term risk.
Once again, to grab the show notes for today’s episode, just head over to youstaywealthy.com/189.
Thank you, as always, for listening and I’ll see you back here next week.
Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.