Alternative Investments

How Risky Is Cash?

Be prepared: If inflation kicks up, you could end up losing purchasing power

A recent post from the Fidelity Viewpoints blog, authored by Claus Tewildt, SVP of Capital Markets Strategy, poses a simple question: AM I holding too much cash? Access the full report here. Reprinted with permission.

The headline is a trick question, of course. When you leave money in cash—whether in a savings or checking account, or under the mattress, it’s not at risk of losing market value like money you invest in stocks. But there is a risk, one that you didn’t have to worry much about for decades, but might become a presence in our lives again going forward: inflation.

In its simplest form, you can think of inflation as the rise in price level in an economy over time. It sounds harmless enough, but it can negatively affect the value of your money. That’s because with a rise in price levels comes a loss of purchasing power.

So what does this have to do with your cash?

Well, the rate of inflation is likely to increase as the economy reopens—not back to the double-digit levels of the 1970s but significantly above the barely noticeable levels of recent decades. Economists think inflation could almost double from 1.7% now to 3% or more over the summer. At the same time, your money invested in a savings account is still yielding just about nothing.

Look At The Math

Let’s do some simple math with round numbers here:

0% return – 3% inflation = −3% return
(Not on your statement but in actual purchasing power)

In a world where the inflation-adjusted return on savings accounts is negative and perhaps becoming more negative, I have been asking myself this question: How much money do I really need to have parked in cash right now? (By the way, this also pertains to your checking and money market accounts.)

How Much Do You Need In Cash?

The answer is not zero because we all need some money readily available for our daily lives and for emergencies. As a rule of thumb, Fidelity recommends holding cash or cash equivalents to cover at least 3 to 6 months of expenses in case of emergencies like a job loss or illness. The exact amount, of course, is a highly personal decision and very much dependent on your individual situation and your risk preferences. For myself, I like to have a bit more so that if I lose my job, I don’t have to worry about cutting back on my lifestyle, or possibly having to sell my investments at an inopportune time. The rest I do invest.

Having seen a lot of client portfolios lately, it is my impression that there is a significant amount of money on the sidelines and destined to lose purchasing power right now if inflation rises to levels that are noticeable. If you are in the same camp, you should at least consider moving some of your money into areas that have the chance to beat inflation.

The array of possible investments is endless. (For an in depth look at the potential risks and rewards of various options, read Viewpoints: What to do with your cash.) But let’s keep it simple for the purposes of this article and focus on 3 different alternatives organized by the primary risk you would have to take on. Risk is the unfortunate byproduct of investing—with a larger return opportunity comes greater, mostly short-term, volatility. The 3 different risks I want to briefly discuss are interest rate risk, credit risk, or stock market risk.

Alternatives To Cats… And The Risks

In its simplest form, you can think of inflation as the rise in price level in an economy over time. It sounds harmless enough, but it can negatively affect the value of your money. That's because with a rise in price levels comes a loss of purchasing power...

Interest rate risk is the risk that you assume if you invest in bonds that pay you a fixed interest rate over time: If market rates go up, you risk missing out on those higher rates. A good example of this would be investment-grade bonds. The advantage of these investments is that their yield is higher than your savings account or money market fund, but they could go down in value if interest rates rise. While you might think that a rise in interest rates is almost a foregone conclusion, history actually shows that you rarely lose money in investment-grade bonds. Examples of investments to consider at this time for this particular asset class would be intermediate investment-grade bond funds or high-quality municipal bond funds.

Bond Returns: Worst Case Scenario?

Since 1926, bonds have experienced 12 down years, versus 25 for stocks. In all but 2 periods, equities were up and often by a large magnitude in years when bonds sold off. Over the 40-year period between 1941 and 1981, during which rates rose by about 1,200 basis points, the worst annual loss for bonds was −3.2%. (A basis point is 1/100th of 1%.)

Credit risk is the risk that the issuer of a bond you bought is unable to pay you back and defaults. That sounds like a big risk to assume, but if you invest in an actively managed, well-diversified investment option, that risk generally becomes manageable as you’re compensated with a higher-yielding interest rate. It also should be noted that most of these defaults usually happen during economic recessions, which does not appear to be an imminent threat. An asset class that I like right now with this higher risk profile is floating-rate notes, as their interest rates are adjusted quarterly based on market rates.

Stock market risk is the risk that you assume when investing in the stock market. In general terms, equity markets have risen on average by an amount that has handily beat inflation. But historically for these long-term rewards you have to endure about 3 corrections of 5% per year, one of 10% per year, and every 3 years one that is greater than 20%. If you can stand this kind of volatility, stocks are probably your best option for beating inflation.

Which Option Or Combination Of Options To Choose?

Well, that depends on you and your personal situation. The main considerations for that decision are probably your risk tolerance and how dependent you are on your investments to fund your daily life now. If you depend on your investments for income, you should be on the more cautious side, consider investing extra cash in high-quality bonds, for example. But if you have a steady income and a long way until retirement, you should probably be more aggressive and consider investing some of your excess cash in stocks.

My key hope with this article was to make you aware of the hidden costs of inflation this year and to inspire you to examine your asset allocation by asking yourself: How much money do I really need on the sideline right now?