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Interest Rates Are High. But Should I Still Hold Cash in My Portfolio?

Even with High Interest Rates, Should You Still Hold Cash in Your Portfolio?
Even with High Interest Rates, Should You Still Hold Cash in Your Portfolio?

With some bank CDs paying more than a 5% APY and some savings and money market accounts yielding around that figure too (as of June 2023), no one can blame investors if they’ve become tempted to keep a healthy chunk of their retirement savings in cash and cash equivalents. But if you’re not careful those high interest rates could end up losing your money in retirement.

Do you have questions about how to allocate the assets in your portfolio according to your goals? Speak with a financial advisor today.

Risks of Holding Cash

Keeping significant cash allocations can make sense to meet your short-term retirement income goals for a year or two, writes Amy Arnott, a certified financial analyst (CFA) and portfolio strategist for Morningstar Research Services. Beyond that time horizon, “Cash can be particularly detrimental to long-term investment goals such as retirement.”

Arnott gives this example: “A retiree who started saving $10,000 per year in 1993 and stashed everything in cash would have ended up with about $380,000 by the end of 2022, compared with about $1.5 million if the savings were invested in an all-equity portfolio or $1 million if invested in a balanced fund.”

One reason to be wary of higher-rate cash accounts is that those interest rates tend to move higher during periods of higher inflation. In today’s case, rates have been pushed up by the Federal Reserve’s decision to hike rates 10 times during the past 16 months to tamp down rising inflation. As the Fed raised its benchmark federal funds rate from 0.25% in early 2022 to 5.25% as of May 2023, it’s important to remember that inflation was running at an annual rate of 8.54% when the Fed got started.

Now that inflation has dropped to about 4%, bank savers can make a small bit of profit on high-yielding accounts – but that won’t last for long. In addition, the rates banks pay typically lag the rates set by the Fed, as they’ve done for most of the post-pandemic period, making any real gains after inflation a brief occurrence, at best. With inflation dropping, one-year CD rates are now higher than five-year rates, an indication that bankers expect the Fed to pause or even cut rates as the cost of living falls.

Reasons for Holding Cash

Even with High Interest Rates, Should You Still Hold Cash in Your Portfolio?
Even with High Interest Rates, Should You Still Hold Cash in Your Portfolio?

The reason financial planners advise their clients to invest in the stock market is because it’s nearly impossible to beat long-term inflation with cash. Historically, only stocks have demonstrated the capability to generate gains after inflation over any long period. As rates fall, cash is likely to return to its position as one of the least-loved types of assets in its traditional role as a financial “parking lot.” That is, a vehicle where investors stash cash for immediate or short-term needs. However, cash accounts can shine when used for the right purposes, including:

Emergency Funds

Whether it’s the minimum three-months of spending or a year or more, an emergency fund needs to be safe and readily available. Often CDs, savings and and money market accounts are ideal for this purpose.

Short-Term Needs

In the bucket approach to retirement investing, assets are separated into long-term, medium-term and short-term buckets that align with when retirees will need that money. A year or two of living expenses in cash insulates them from market shocks and allows investors to ride out periods of stock volatility. It also mitigates sequence-of-returns risk, a problem that occurs when a period of poor market performance early in retirement creates larger-than-average portfolio losses, making future retirement withdrawals difficult to sustain.

Anticipated Spending

Savings for the down payment on a home, wedding costs or to pay upcoming college tuition bills shouldn’t be stuck in stocks. This is particularly true if that money will be needed in the next few years, when a market decline could leave money invested in stocks coming up short.

Buying Time to Think

An inheritance, lottery winnings, unexpected bonus or other unexpected windfall can be parked in an FDIC-insured bank CD or money market account. This throws off a bit of interest, while the recipient decides just how to invest or spend their bounty.

Bottom Line

Investors who need to hold some amount of their assets in cash should enjoy the temporarily higher-than-usual rates on bank CDs and money market accounts. Just remember that, as an investment, cash is strictly for covering anticipated short-term needs.

Tips on Investing

  • How much money to keep in cash, bonds and stocks can be a complicated balancing act that shifts widely from your working years to retirement. A financial advisor can help answer how to structure your holdings. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

  • Fidelity recommends that you have 10 times your annual income saved for retirement by age 67. To find out if you’re on track, try SmartAsset’s retirement calculator. This will estimate how much you’ll have when the time comes to retire.

Photo credit: ©iStock.com/Cimmerian, ©iStock.com/designer491

The post Even With High Interest Rates, Should You Hold Cash in Your Portfolio? appeared first on SmartAsset Blog.

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