The Cost of Cash

March 2010

Overview: In tough market times, many investors flee to the safety of cash equivalents. It is important to realize the costs associated with comfort and safety.

A 2009 SmartMoney article put it best when describing cash accounts: “While these holding places may seem no different from a savings account to the average investor, experts say they are one of the worst places to park your cash.”¹

To be sure, cash accounts play an important role in a portfolio. New deposits may go into a cash account for a period of time until new assets are purchased. These accounts can also hold money used for advisor fees, so investors don’t have to sell assets when those bills arrive.

However, SmartMoney noted that even custodians discourage using cash accounts long term: “In their defense, brokerages say their cash accounts are only supposed to be temporary holding tanks, not long-term investments.

“Paying interest on the accounts has become an industry standard, so the brokerages do pay a nominal rate, but earning interest is not the purpose, says Jim Frawley, a spokesperson at TD Ameritrade … ‘It should be used for buying and selling; it’s not for long-term cash.’ And brokerages acknowledge that investors can — and should — find higher rates elsewhere.”²

Higher Rates Elsewhere

Cash equivalents, on the other hand, typically pay more than cash accounts due to factors such as risk or lockup periods. Here are a few of the most common options:

1. CDs — CDs are promissory notes issued by banks and have maturity dates, typically between
   30 days and five years. They are backed by the Federal Deposit Insurance Corp. up to $250,000 per bank account holder.
2. Money market accounts — Money market accounts invest in instruments typically found on the safer end of the investing spectrum, such as large bank certificates and government paper.
3. U.S. Treasury bills — T-bills are backed by the U.S. government. They are available directly from the government, and the income is exempt from state and local taxes.

These may not have the expected returns of equities, but the difference between these investments and sitting in cash can be noticeable. For example, $100,000 in one of Fidelity’s money market funds for all of 2008 would have earned nearly $3,000 in interest versus $420 by staying in cash.

Times of Crisis

During times of investment crisis, many investors flee to safer investments, and this past crisis was no exception. Since the start of 2008, equity funds have experienced $232 billion worth of outflows.

Even with alternatives available, many investors may still feel safer staying in cash. However, there are several issues that need to be considered, including the fact that sitting in cash could cause investors to fall behind, thanks to inflation.

Inflation

Investors who are sitting in cash run the risk of inflation eroding their spending power. In the majority of years, cash accounts can keep up with or slightly outpace inflation. However, the returns of 30-day Treasury bills (which represent the returns of cash accounts) were behind the rate of inflation in 20 of the 64 rolling 20-year periods between 1926 and 2008.³

Once taxes are figured into the equation, the figures look worse. According to Morningstar, cash holdings earned an average of 3.7 percent per year from 1926 through 2008, while inflation averaged about 3 percent per year. However, the after-tax returns of cash accounts were about 2.3 percent (though taxes are currently lower than has historically been the case).⁴

Finally, CBS MoneyWatch noted in November 2009: “All inflation is not created equal. Some things go up a lot, even when most prices remain stable or even decline. One is college tuition, and another is health care, a major concern for retirees. Even stocks may not keep pace with health care inflation (currently in the double digits, according to Buck Consultants) — and cash has no chance.”⁵

Current Rates and Future Rates

This may lead some to say, “Well, I’ll just wait until rates go up.” What these investors have failed to consider is that rates would have to increase significantly to make up for the ground they lost waiting for the rates to go up.

Consider this example. A three-year bond is yielding roughly 2.9 percent. Let’s say you wanted to wait to see if rates go up. If you end up waiting a year for better rates, you’d have to hope rates on two-year bonds jump all the way to 4.3 percent to break even.

The same thing is true if you stretch it out to five years. Let’s compare buying a five-year bond with sitting in a CD for a year hoping for higher rates, then buying a four-year bond to cover the time gap. A five-year bond currently yields roughly 3.0 percent. By sitting in cash for a year, you would have to find a four-year bond paying 3.6 percent just to break even.

Summary

When investor confidence gets shaken, sitting in cash can feel comfortable. However, that comfort comes at a price, and some investors might not realize how steep that price can be. It is important to realize the costs associated with comfort and safety.

¹   Janet Paskin, Your Money…Swept Away. SmartMoney, February 11, 2009.

²   Ibid.

³   Max Alexander, Why You Shouldn’t Bash Cash. CBS MoneyWatch, November 19, 2009.

⁴   Ibid.

⁵   Ibid.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Copyright © 2010, Buckingham Family of Financial Services.