Ultimately, the conversation around cash and traditional long-term assets should not be framed as “either/or”, but rather as “both, for different reasons.”
For the better part of the last 15 years, cash has decidedly not been “king.” More recently, however, the relative attractiveness of cash instruments has increased. The Federal Reserve (Fed), working to fight persistent high inflation, has raised rates at the most aggressive pace in decades and to the highest level since the Great Financial Crisis. This, in turn, has lifted cash yields, and the average 6-month Certificate of Deposit (CD) in the U.S. now has an annualized yield of 1.86%, with some 12-month CDs offering yields of nearly 5%. As a result, for the first time in a long time, cash is no longer just a parking lot for “dry powder”; instead, some may believe that it can further income goals, too.
However, despite the rapid rise in yields, investors must consider if CDs and other cash instruments are the best place to allocate capital. In other words, they must ask: should CDs be a part of portfolio construction?
As with many things in today’s investment universe, the answer to this question is not black or white, but rather gray. Investors may therefore be best served by thinking about asset allocation in terms of both liquidity and income needs and also opportunity cost.
All investors have liquidity and income needs. These needs are amplified or diminished by a number of factors, including risk tolerance, age and wealth. To address these needs, a simple framework would be a good place to begin the asset allocation discussion:
- Identify typical liquidity or income needs (e.g., average annual expenditures).
- Identify atypical liquidity needs that may arise (e.g., medical expenses) or are expected (e.g., purchasing a second home).
- Determine how many years of risk-free liquidity or income is required, based on risk tolerance.
- Build up a cash reserve based on the aforementioned criteria. These cash reserves can be constructed using CDs (which have the added benefit of FDIC insurance) or Money Market Funds (MMFs), which lack insurance but are still ultra-high quality, have no lock-up period, and in some instances have a superior yield and have seen significant inflows in recent months.
Once liquidity needs are addressed, investors should consider opportunity cost and allocate every extra dollar to risk assets. Some considerations include:
- Significant negative performance in 2022 has set the stage for a powerful rebound in the stock market. For example, the S&P 500 is still 15% off its January 2022 peak of 4,797 despite a recent run higher. Even annualized over a multi-year recovery period, this figure is more impressive than the typical cash yield.
- Many high quality fixed income instruments have yields that are comparable to cash. In addition, these yields can be captured for longer provided the instrument has sufficient duration (high CD yields are likely fleeting, especially if the Fed lowers interest rates in 2024).
- Within the fixed income universe, duration has the added benefit of providing a buffer against volatility in a portfolio, especially in the case of a recession. For example, a 1% parallel shift lower in the Treasury yield curve will result in a return of 11% from the Bloomberg U.S. Aggregate index.
Ultimately, the conversation around cash and traditional long-term assets should not be framed as “either/or”, but rather as “both, for different reasons.” It is impossible to dismiss that cash remains a safe-haven asset and has become a viable income generator; but it is similarly impossible to dismiss the notion that there are not better places to park excess capital. For this reason, investors would be wise to take a holistic approach to asset allocation and continue to embrace risk in portfolio construction.