Rising interest rates make this a good time to learn how to manage cashA recent Fidelity Viewpoints Blog looks at market trends that are bringing returns from cash into line with stocks and bonds. Reprinted with permission. Learn more at fidelity.com.
If you are like many people, you probably have some cash in a checking account for day-to-day spending, some savings for major purchases or unexpected expenses, and hopefully, an emergency fund with enough cash to pay for 3 to 6 months’ worth of household expenses. But what if you have more cash than that in your checking, savings, or investment accounts? What should you do?
For the past decade or more, the obvious answer for many people has been to invest it in stocks. During that time, US stocks were enjoying a long bull market and most other options for cash were paying very little thanks to low interest rates. Now, though, with stocks in a bear market and the Federal Reserve continuing to raise rates, the answer to the question of what to do with your cash may be less clear than it had been.
The economic situation is complicating that question too. According to Fidelity’s Asset Allocation Research Team, the US economy is not in a recession but it is in what economists call the late phase of the business cycle. That’s a time when history shows that stocks, bonds, and cash have all delivered similar returns, unlike most of the time when both stocks and bonds have outperformed cash.
The opportunity to earn returns that are competitive with other assets while also enjoying the low volatility and easy access to your money that cash offers sounds attractive but that doesn’t mean you should sell your stocks or bonds and hoard cash instead. Stocks and bonds have both outperformed cash over the long term and the short-term appeal of cash isn’t a good reason to change your long-term allocations to stocks and bonds if it is appropriate for your goals, risk tolerance, and time horizon. However, if you find yourself with more cash than you need for expenses and emergencies, you may have a variety of attractive options in today’s marketplace.
To be sure, not all those options are equally attractive—Treasury bills and CD yields have been much higher than bank savings accounts. Fidelity makes it easy to see the current rates on popular places to put your cash. Don’t assume, though, that the highest rates are always the best choice. It’s important to understand both your own needs and goals as well all the differences between the various places to put your cash.
Consider Your Goals, Both Long Term And Short Term
As you think about whether to stay in cash or to invest, think about the role cash plays in your overall financial plan. How much do you need to pay for your expenses, both planned and unexpected? How much do you need for a major expense such as college tuition within the next few years? Are you willing to accept lower returns from your investment portfolio in the future that could result from keeping more money in cash, rather than investing it in stocks and bonds?
How Long Should You Stay In Cash?
Holding significant amounts of cash may provide reassurance during market volatility. But over the long term, leaving overly large amounts of cash uninvested in your portfolio can be a drawback. Historically, both stocks and bonds have delivered higher returns than cash and professional investors are careful to avoid over-allocating assets to cash. For this reason, investment management services such as those offered by Fidelity’s managed accounts do not allocate large amounts of money to cash, but instead stay invested.
Here are some places to keep your cash with the goals of keeping it safe and accessible, and earning interest as well.
Savings accounts at banks offer flexibility and insurance from the Federal Deposit Insurance Corporation (FDIC). Some brokerage firms offer cash management accounts, which automatically move cash in their clients’ accounts into bank savings accounts which provide them with FDIC protection.
Liquidity and flexibility: Savings accounts are liquid. That means you can access your savings when you need or want to.
Insurance: FDIC insurance means the government would insure you against losing your money if the bank were to fail. The insurance covers losses of up to $250,000 per person, per bank, per account ownership category. That limit may require you to spread your money across accounts at several banks in order to make sure all your money is insured.
Uses: Savings accounts can be good places to put cash that you need ready access to for bill paying or emergencies.
Money Market Mutual Funds
Money market funds are mutual funds that invest in short-term debt securities with low credit risk and yields that tend to closely track changes in the direction of the Fed’s target interest rate. There are 3 main categories of money market funds—government, prime, and municipal.
Government funds hold Treasury and other securities issued by the US government and government agencies. Prime retail money market funds do too, but they may also invest in securities issued by corporations. Municipal retail money market funds invest in debt issued by states, cities, and public agencies.
Liquidity and flexibility: Government funds, including US Treasury money market mutual funds, are priced and transact at a stable $1.00 price per share or net asset value (NAV) and are not subject to the potential restrictions on withdrawals such as liquidity fees or redemption gates.
During periods of extraordinary stress, both prime and municipal money market mutual funds may charge redeeming shareholders liquidity fees or provide for redemption gates that would temporarily halt all withdrawals.
Insurance: Money market funds are not insured by the FDIC. The Securities Investor Protection Corporation (SIPC) provides insurance for brokerage accounts that hold money market funds. SIPC protects against the loss of cash and securities—such as stocks and bonds—held by a customer at a financially troubled SIPC-member firm. SIPC protection is limited to $500,000 and has a cash limit of $250,000. SIPC does not protect against declines in the value of your securities and is not the same as FDIC protection.
Uses: Money market funds can offer easy access to your cash and may make sense as places to put money you might need on short notice, or that you are holding to invest when opportunities arise.
Deferred Fixed Annuities
A deferred fixed annuity is a contract with an insurance company that guarantees a specific fixed interest rate on your investment over a set period of time—generally 3 to 10 years. It is geared toward investors looking to protect a portion of their retirement savings from the effects of market volatility while locking in a competitive rate of return with minimal risk for that portion. With a deferred fixed annuity, all taxes on interest are deferred until funds are withdrawn and there are no IRS contribution limits.
Liquidity and flexibility: With some deferred fixed annuities, you can take annual withdrawals of up to 10% of your contract value without incurring a surrender charge. Additionally, you can choose the guarantee period length that fits your goals.
Insurance: Your principal and interest are backed by the issuing insurance company. Since an annuity’s guarantees are only as strong as the insurance company providing them, you should consider the strength of the company you select and its ability to meet future obligations.
Uses: If you are looking to protect a portion of your savings with the security of a guaranteed rate of return, while also deferring taxes, then a deferred fixed annuity may be right for you.
Certificates Of Deposit
CDs are time-deposit accounts issued by banks in maturities from 1 month to 20 years. When you buy a CD, you agree to leave your money in the account for a specified period of time. In return, the bank pays you interest at a rate that is fixed at the beginning of that time period. CDs may offer higher yields than some other options for cash, but you may have to lock up your savings for a set period of time or pay a penalty for early withdrawal.
You can buy a CD directly from a bank, or you could buy one through a brokerage firm, known as a “brokered CD.” If you buy a brokered CD as a new issue CD at Fidelity, there are no management fees or transaction costs if you hold it to maturity.
Liquidity and flexibility: Because you can avoid those fees and transaction costs, it makes sense to hold CDs until maturity. If you own a CD in a brokerage account and need access to your savings before maturity, you will likely have to sell it for a loss and also pay transaction fees. Banks may charge fees for early withdrawals. One way to improve access to your money and avoid fees with CDs may be by building what is known as a ladder. A ladder arranges a number of CDs with staggered maturities. This frees up a portion of your investment at preset intervals as each CD matures and with rates rising, may help you to reinvest funds at higher rates as the rungs in your CD ladder mature.
Insurance: CDs are eligible for FDIC insurance. A brokerage account can aggregate brokered CDs from different FDIC banks in one account, so you may be able to put more than $250,000 in CDs without running into the FDIC insurance limit.
Uses: Because they should be held for specific lengths of time, CDs are more useful for earning yields and preserving cash rather than for holding cash that you may need to access before the CD matures. They can also offer a simple, safe, way to offset riskier assets in an IRA where you may not need access to your cash.
Individual Short-Duration Bonds
If you have cash that you don’t need access to immediately, you may want to consider putting some in short-duration bonds, which carry slightly more credit or interest rate risk than savings accounts, money markets, or CDs while potentially offering more return.
The 4 categories of short-duration bonds—US Treasury, corporate, tax-free municipal, and taxable municipal—offer a variety of maturities and levels of risk. Treasury bonds are backed by the full faith and credit of the US government.
Corporate bonds are securities issued by companies and municipal bonds are issued by states, cities, and public agencies. Both corporate bonds and municipal bonds contain credit risk which typically rises as their advertised yields rise.
Liquidity and flexibility: Fidelity suggests holding short-term bonds until maturity. You can sell your bonds before maturity if you choose. However, you may not be able to find a buyer, forcing you to accept a lower price if you need to sell your bond. If interest rates rise, the price of your bond will fall, so if rates have gone up since you bought your bond, you may experience a loss if you sell it before maturity. These risks mean it is important to consider whether a bond is an appropriate alternative investment for your cash. You should also try to diversify among individual bonds, perhaps by holding a number of securities from different issuers. You may need to invest a significant amount of money to achieve diversification. You also have to pay fees when you buy or sell individual bonds in the secondary market. Like CDs, bonds can be laddered.
Insurance: SIPC insurance is available for brokerage accounts that hold bonds, subject to the limits previously mentioned.
Uses: Short-term bonds’ prices can rise and fall more than those of other cash alternatives, so they are more useful for those willing to hold them until they mature than for those who may need cash soon.
Short-Duration Bond Funds
Some bond funds track the performance of an index while others are actively managed using professional credit research and portfolio construction. Those services come with fees. Fidelity’s Mutual Fund Evaluator can provide examples of short-duration bond funds. You should do your own research to find bond funds that fit your time horizon, financial circumstances, risk tolerance, and unique goals.
Liquidity and flexibility: You can buy and sell bond funds each day. Most bond funds have no maturity date, so your return will reflect the market prices of the bonds held by the fund at the time you decide to buy and sell. The value of your investment will change as the prices of the bonds in the fund’s portfolio shift, and those market moves could add to your yield, or reduce it.
Insurance: SIPC insurance is available.
Uses: Similar to a diversified portfolio of individual short-term bonds, bond funds are better for earning yield over time, rather than for use in emergency funds or for cash needed to pay for anticipated expenses. Keep in mind, though, unlike investments which offer a specific rate at the time you purchase them, you do not know in advance what the return on a bond fund will be.
Longer-Term Questions—And Answers
If you have cash, you not only have options to consider about where to put it now, but you also need to decide how much of it to invest for the future in stocks and bonds as well as how to do so. These considerations become increasingly more important, and more complex as your cash position grows—whether from compensation, bonuses, cash generated when selling shares acquired through company stock programs, or other windfalls.
History shows that investing in stocks and bonds rather than sitting in cash can make a significant difference in investors’ long-term success. If you can’t tolerate the ups and downs of the stocks in your portfolio, however, consider a less volatile mix of investments that you can stick with.