15 Dec Alternatives to Cash
We have received several questions from clients recently regarding alternatives to holding cash in a savings account. This is a good question to ask given the interest rates offered on savings and the current inflation rate, which just hit a 31-year high. People are rightly concerned that the value of their savings is being eroded by inflation. Unfortunately, at the current juncture, there aren’t any great solutions to this conundrum. We wanted to write a blog explaining what the issues are, how we got here, and what the best course of action is going forward.
As most everyone knows, banks are currently paying little to nothing on deposits, but it wasn’t always this way. Like interest rates broadly, the interest rate paid by banks on deposits (such as checking and savings accounts) has fallen sharply since cresting in the late 70s. Historical data on the rates on deposits is very difficult to find for periods before 2009. The following graph shows historical interest rates paid on 3-month Certificates of Deposit (CDs). CD rates are typically higher than the rates on savings accounts, but 3-month rates are a reasonable proxy. They also represent actual rates individuals could get on a very safe short-term investment historically. As you can see, rates have crashed from over 18% in the late 70s to almost zero today.
Another very safe, short-term investment that investors were able to utilize in the past was short term treasuries. In general, treasuries are regarded as perhaps the safest investment available– they have zero default risk; and short-term treasuries (as compared to long-term treasuries) have the added benefit of very low interest rate and duration risk. Furthermore, the treasury market is extremely liquid meaning these bonds can be sold very quickly if the funds are needed prior to the maturity date. Short-term treasuries have also historically paid an equal or higher interest rate than the rate of inflation, helping investors maintain their purchasing power.
However, since the Global Financial Crisis of 2008, short term treasuries have spent the majority of the time at extremely low rates and below the inflation rate. This means that not only were short-term treasury owners receiving very little return on their investment, they were also losing purchasing power despite that investment- this is known as a negative real rate of return. The most likely cause of rates being historically low and below the inflation rate is the unprecedented quantitative easing undertaken by the Fed in response to the 2008 and 2020 recessions- few would argue that rates would be where they are today absent any Fed intervention.
One of the hard facts we have to face in investing today is that there simply isn’t a great option for very safe, very liquid, short-term investments. While investing in a short-term Treasury fund, for example, will earn something, you’re still virtually guaranteed to lose purchasing power to inflation while taking on the risk that rates rise and your investment declines in value.
Given all that we know about the current environment, here are our suggestions:
1. Don’t hold more cash than you need.
- We always recommend clients have an adequate emergency fund before investing their cash. We have written more extensively about emergency funds here.
- Given the current inflationary environment, it may be worth reevaluating the target for your emergency fund since costs have risen.
- Be aware that holding too much cash can potentially give you more exposure to inflation. Excess exposure to inflation risk can materially impact inflation-adjusted returns over the long run.
2. If you have a specific need for cash on a specific date, there are a couple of options.
- Hold the full amount needed in cash in a bank account.
- Purchase a very high-quality bond (such as a treasury) that matures just before you will need the cash. This allows you to earn some interest and offset some of the effects of inflation. This strategy also mitigates some of the risks associated with bonds.
- If your cash needs are more than 3-5 years in the future, it may be appropriate to invest the funds in a more diversified portfolio.
3. If you have no specific needs for the cash, consider investing the excess cash in accordance with your overall asset allocation.
- The benchmark we use to compare performance for 50-50 accounts returned just under 9% over the past year (12/15/2020 – 12/14/2021). Past performance is no guarantee of future results, but you can see how a conservative diversified portfolio handily outperformed the high rate of inflation over the past year.
Stocks, Real Estate Investment Trusts (REITs), and physical real estate are typically regarded as some of the best inflation hedges. For physical real estate most people own their own home, which should hold up well during inflation. We tend to allocate a portion of client portfolios to REITs as well. We also tend to hold Treasury Inflation Protected Securities (TIPS) and Senior Loans. TIPS pay a floating interest rate based on the actual rate of inflation, which benefits investors when inflation rates rise; and Senior Loans typically have also have floating rates meaning investors receive more income when interest rates rise- a common response in high inflation environments. For these reasons, a portfolio holding all these asset classes may hold up well when inflation starts to run hot.
The bottom line is holding too much cash, while giving the illusion of safety, can actually be detrimental- especially in high inflation, low interest rate scenarios. Holding an appropriate amount of cash and investing the rest in a well-diversified portfolio that includes the asset classes that have historically performed well in inflationary environments best positions you for success over the long run.
If you are unsure about the right amount of cash to hold, talk to one of our CERTIFIED FINANCIAL PLANNERS™ today!
Important Disclosure: Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this blog, will be profitable, equal any corresponding indicated historical performance levels, or be suitable for your portfolio. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of or as a substitute for, personalized investment advice from Metis Wealth Management & Planning. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. A copy of our current written disclosure statement discussing our advisory services and fees is available for review upon request.