Portfolio Perspective –

Portfolio Perspective

June 28, 2023

Beyond cash – Risk and opportunities

Key takeaways

Staying in cash comes with its own risks, which a diversified approach can help mitigate

  • Even though cash is now yielding a higher return, it is not a riskless investment choice. Keeping all or most of a portfolio in cash can introduce investors to other types of unintended risks.
  • Those risks can include reinvestment risk in the face of declining rates, decaying purchasing power through stickier inflation, and the opportunity costs of missing the higher return potential of a diversified stock/bond portfolio. But the biggest risk of all is not being able to achieve the goals of one’s financial plan.
  • To have cash or not to have cash shouldn’t be an all or none question. Instead, employing an approach to diversify a portfolio across various investments, including some cash, can help mitigate these risks. 

As we approach the end of the fastest interest rate hiking cycle by the Federal Reserve (Fed) in 40 years, yields on cash and cash equivalents are now offering attractive returns that haven’t been seen in over 15 years. Given these elevated yields and the memory of 2022’s volatile market, investors might be tempted to keep higher-than-normal cash levels and earn that income. However, keeping a large amount of one’s investment assets in cash introduces its own set of risks that investors should consider, including reinvestment risk, purchasing power risk, and opportunity cost.  

1) Reinvestment risk

One important risk to consider when staying in cash is reinvestment risk, the risk that investors would experience lower yields as interest rates decline. The current high cash yields may not stick around forever. Since cash and cash equivalents earn very short-term interest rates, it doesn’t “lock in” that elevated yield for a longer period and is subject to lower yields if the Fed’s policy rates begin to decline. In contrast, longer-maturity bonds can allow investors to lock into their stated rates, even if short-term cash return rates decline. Additionally, if the Fed cuts rates aggressively in the face of a recession, longer-dated fixed income is likely to see greater price gains as well as playing its part as portfolio ballast, helping offset equity volatility.

2) Cash’s purchasing power reduced by inflation

Inflation can also chip away at cash’s purchasing power for investors. It is an acutely noticeable, and sometimes painful, erosion of value in periods of high inflation such as the 1970s or in the current environment. Additionally, even in benign inflationary environments such as the past 30 years, the deleterious impact on investors’ purchasing power can be felt over time. Maintaining a higher-than-needed cash allocation in portfolios, especially in the current inflationary environment, will further impede investors’ ability to achieve their financial goals.

3) Market timing risk

Waiting for the right opportunity to enter and exit the stock market can have its own risk. In times of market volatility, some investors either increase their cash holdings or opt to stay in cash and wait for ‘the coast to clear’ before deploying that cash into the market. This market timing tactic also entails risk — the risk of missing out on some of the best return days, leaving investment portfolios behind in helping investors achieve their financial goals. Market rebounds off the lows in a volatile period can be unexpected and sometimes very strong. Investors risk missing out on those impactful up market days as they wait for the right opportunity. The chart below highlights such risks, where missing out on a handful of those impactful days can result in a meaningful lag in investment results compared to staying in the market for the total period. 

Cash vs. the stock and bond dynamic duo

Over time, a balanced asset allocation approach consistent with risk tolerance can help investors meet their financial goals. When comparing a balanced portfolio of stocks and bonds against cash, the evidence is even more compelling. Over the long term, not only do stocks and bonds outperform cash separately, the combination of the two outperforms cash in even more instances. Moreover, the diversification benefits allow bonds to be the ballast in a portfolio, helping to offset stock volatility.

Bottom line

Investors may be tempted in the current environment to stay in all cash given the prevailing elevated yields. However, historical evidence illustrates that this approach comes with risks, such as reinvestment risks, market timing risk, missing out on the long-term returns stocks and bonds can achieve, and risking the erosion of purchasing power through inflation. While staying in or further allocating to stocks in drawdown periods feels uncomfortable, overlooking the risks of staying in cash might put investors behind in achieving their financial goals and plans. An approach that includes a diversified set of investments such as bonds, stocks, alternatives, and private markets may help mitigate the risk of a cash-only approach and should help investors achieve their financial goals.

To read the publication in its entirety, please click the button below "Download PDF".

The latest research & insights