By: Reed C. Fraasa, CFP®, AIF®, RLP®
In personal finance, the attraction of cash equivalents for long-term goals has persisted as a seemingly safe and stable investment strategy. Cash equivalents, including savings accounts, money market funds, certificates of deposit (CDs), and Treasury bills, are often viewed as low-risk options that offer liquidity and "preservation of capital." However, the belief that investing primarily in cash equivalents can secure one's financial future in the long term is a myth that should be challenged.
The term "preservation of capital" can be interpreted in two ways: as a safety net from loss and as protection from loss due to inflation. When asked if they are concerned about capital preservation and what it means to them, many investors typically describe the need to protect their existing capital by choosing low-risk investments that prioritize the security of their funds over potential growth. This belief will lead them to overvalue safe assets like Treasury bills, certificates of deposits (CDs), money market funds, and undervalue growth assets like stocks and some bonds.
While cash equivalents may provide security and accessibility, they fall short regarding capital appreciation and wealth accumulation over extended periods. Unlike stocks, bonds, or real estate, which have historically delivered significant returns over extended periods, cash equivalents offer minimal growth opportunities.
In today's dynamic economic landscape, relying solely on cash equivalents for long-term goals is a fallacy that can hinder financial growth and jeopardize future prosperity. However, maintaining emergency funds and short-term reserves in liquid assets like cash equivalents is prudent.
As financial advisors, we first want to establish how much money a client will need to meet short-term goals – funds to spend over the next five years. After establishing short-term needs, further investing in cash equivalents exposes investors to the risk of losing purchasing power due to inflation. Inflation is the increase in the prices of goods and services over time, reducing the actual value of money. While cash equivalents may preserve nominal capital, they often fail to keep pace with inflation, leading to a decline in real purchasing power over the long term.
The irony is that, although the loss-averse investor may desire to avoid temporary losses by limiting their ownership of stocks and bonds, they expose themselves to the more permanent loss of purchasing power over the long term. Stocks and bonds have always recovered within a reasonable period, but it is almost impossible to recover from a loss of purchasing power due to inflation.
For instance, suppose an individual invests $100,000 in a savings account, earning a nominal interest rate of 1% per year. Meanwhile, the inflation rate averages 2% annually. After ten years, the nominal value of the investment may have grown to approximately $110,462. However, when adjusted for inflation, the asset's actual value decreased to around $90,400 in today's dollars. In essence, the investor has experienced a loss of purchasing power despite nominal capital appreciation.
Following the Great Recession, from March 2009 to March 2016, short-term interest rates were 0% to 0.25%. Rates peaked at 2.25% to 2.50% at the end of 2018 and fell to 0% to 0.25% by March 2020, remaining near zero until May 2022.
Over those thirteen years, there was little demand for cash equivalents.
After May 2022, short-term rates escalated from near 0% to 4% at the end of 2022 and to 5.5% by January 2024. This period was the first time in over fifteen years that people saw money market, CD, and T-bill rates resembling historical averages of 3% to 5%.
This recent phenomenon of higher yields on risk-free accounts drove many people to believe they were better off taking the cash yield over the risk of the stock and bond markets. This belief is one of investors' two most common behavioral mistakes with their money. One uses long-term assets (stocks and bonds) to invest in short-term goals, and the other uses short-term assets (CDs and T-bills) to invest in long-term goals.
People now spend time searching for an extra 0.20% rate on a CD over the next six or twelve months and regret it when they hear there is another one that was 0.10% better than the one they invested in. However, they will not spend even half the time learning how much they are losing in purchasing power over the term of the CD.
A closer look at the post-great Recession period reveals how important it is to focus on preserving capital for inflation and losing purchasing power over short-term losses from market volatility.
The Inflation Story 2009 to 2021
From March 2009 to March 2021, while cash equivalent yields* averaged about 0.7% per year, the total return on cash for the entire thirteen years was slightly over 8%.
Meanwhile, inflation averaged about 1.6% per year for the same period, and the total cumulative inflation for the entire thirteen years was almost 25%. That is a permanent 17% loss of purchasing power over the thirteen years (25% - 8% = 17%).
During the same thirteen years, a sample, balanced portfolio comprising 40% US Bonds, 45% US Stocks, and 15% Foreign Stocks**, consistently held for the entire period, grew by over 260%. Those thirteen years included many periods of high volatility and annual drawdowns in the stock and bond markets, but that is the available reward for having tolerated those risks (260% vs. 8%).
The Inflation Story 2021 to 2024
The loss of purchasing power over the last three years is almost as much as the prior thirteen years.
From April 2021 to March 2024, while cash equivalent yields* averaged about 2.4% per year, the total return on cash for the entire three years was a little over 7%.
Meanwhile, inflation averaged over 5.5% per year for the same three-year period, and the total cumulative inflation for the entire thirteen years was over 17%. Using cash equivalents for long-term goals during that period would have resulted in a permanent 10% loss of purchasing power over the three years (17% - 7% = 10%).
During the same three years, a sample, balanced portfolio comprising 40% US Bonds, 45% US Stocks, and 15% Foreign Stocks**, consistently held for the entire period, grew by over 10%. The prior three years included extreme volatility and historical stock and bond market drawdowns but still provided over 40% more preservation of capital from inflation and loss of purchasing power than cash equivalents (10% - 7% = 3% / 7% = 43%).
In conclusion, the belief that it is a prudent strategy to invest in cash equivalents for long-term goals is a myth that fails to account for the realities of inflation. While cash equivalents may offer liquidity and stability, they fall short regarding capital appreciation and wealth accumulation over extended periods. To achieve long-term financial security and prosperity, investors must adopt a diversified investment approach incorporating various asset classes and embracing innovation and strategic risk management. By doing so, investors can position themselves to thrive in an ever-evolving financial landscape and achieve their long-term financial goals.
*The Bloomberg US Short Treasury Index represents cash equivalent yield.
**Sample balanced portfolio represented by 40% Bloomberg US Aggregate Bond Index/45% Russell 3000 Equity Index/15% MSCI ACWI X-US IMI Net Index.
The foregoing content reflects the opinions of Highland Financial Advisors, LLC, and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions, or forecasts provided herein will prove to be correct.
Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns.
Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful or that markets will act as they have in the past.
Reed C. Fraasa is a CERTIFIED FINANCIAL PLANNER™ and founder of HIGHLAND Financial Advisors, a Fee-Only financial planning firm that offers comprehensive financial planning, retirement planning, and investment management. Reed has 30 years of experience as a fiduciary advisor and is the author of The Person is the Plan®, a unique financial planning process. Reed was a frequent guest contributor on PBS Nightly Business Report and has been featured in the New York Times, Wall Street Journal, and Star Ledger newspapers.