Why Cash Is Not a Great Investment (Even With a 5% Yield!)
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Cash is king. The origin of this popular phrase is unknown, but most sources give credit to the CEO of Volvo who allegedly used the expression shortly after the global stock market crash of 1987. He used the phrase to suggest that companies with strong cash reserves were able to weather the recent storm better than others.

Cash was king during that time period, and similar to large publicly traded businesses, retirement investors often build up cash reserves for protection as well. Like Volvo in the late 80s, cash can help retirees weather unpredictable, catastrophic storms.

However, with money markets, high yield savings accounts and bank CDs currently paying four to five percent interest rates, many are now viewing cash as an investment. They're viewing cash as a way to make money, not necessarily as a way to protect their retirement plan against a prolonged downturn in the markets.

Welcome to Stay Wealthy Podcast. I'm your host, Taylor Schulte. And today, I'm sharing why cash is a bad investment, even at today's interest rate levels. To grab the links and resources for today's episode, just head over to youstaywealthy.com forward slash 189.

When evaluating investment returns, there are many different metrics that we can use to measure their performance or the outcome. The two that most investors are typically concerned with or should be concerned with are nominal returns and real returns. The nominal rate of return of an investment is the amount of money made before factoring in things like taxes, fees, and inflation. For

For example, if you invested $100,000 into the S&P 500 one year ago today, and your investment is now worth $110,000, well, your nominal rate of return was 10%. Nominal returns are what most investors pay attention to when reviewing their portfolios. And that's because by ignoring things like fees, taxes, and inflation, investors find it a little bit easier to compare one investment against another.

Not all that different than comparing your gross salary to another person's gross salary. Two people may have the same $100,000 gross salary for the same position, but person A might be in a higher tax bracket than person B due to their, let's say, geographical location and therefore end up with less money in their pocket on payday.

The real return adjusts an investment's nominal return for one important factor, and that is inflation. The real return is the percentage return of an investment after inflation is factored in. It's an inflation-adjusted return. And yes, technically, the real return would also net out things like fees and taxes, but we're keeping it simple today and running with the overly simplified definition of real returns that just simply strips out inflation. So, let's get started.

So going back to our prior example of investing $100,000 in the S&P 500 one year ago today, if the nominal return during that time period was 10% and let's say inflation was 6%, well, the investor's real return was 4%. Inflation, i.e. higher prices for goods and services, ate into the investor's nominal return and their purchasing power.

As you might guess, nominal returns will always be higher than real returns, except when inflation is absent or we're experiencing deflation. But in a normal environment, some level of inflation will exist. Historically, on average, for the last 95 years, it's hovered around 3%. So if you earn 10% on an investment, about one third of that nominal return on average gets eaten up by inflation, sometimes more, sometimes less.

Because everyone is running around quoting nominal returns, real returns are often forgotten. I regularly hear people talk about the early 1980s and the interest rates being paid on their cash and their tax-free bonds, but then fail to reference the rate of inflation during that time period or fail to reference the interest rate that they were paying on their mortgage.

I think psychologically, it just feels better to us to earn a healthy rate of return on our cash, even if our inflation-adjusted return is more or less in line with historical averages, especially coming out of a period where cash in the bank paid nothing for what felt like an eternity. On the surface, earning 5% on our cash certainly feels better than earning 0.1%. But

But now we know that these nominal return numbers only represent one side of the return equation. And in reality, 5% and 0.1% nominal returns might be closer than we think when inflation is taken into consideration and we calculate our real returns.

For example, from May of 2022 until May of 2023, the Vanguard treasury money market fund ticker V U S X X the Vanguard treasury money market fund during this 12 month time period, i.e. risk-free cash in the bank finally paid investors. What felt like a healthy return of about three and a half percent.

But as the recent May inflation report just highlighted, inflation during that 12 month time period from May of last year until May of this year was 4%. So cash investors, while they might have felt like they were finally getting paid to stuff everything under the mattress, they were in fact losing money to inflation, losing purchasing power.

Not all that different than the frustrating time period from 2009 to 2020 when the average return on cash was about 0.4% or basically nothing and inflation averaged around 1.6%.

Yes, cash yields were well below historical levels, but so was inflation. And yes, I'm cherry picking a few recent time periods here to make the point that nominal returns don't tell the whole story. There are time periods like 1978 to 1999 where cash outpaced inflation by about 3% per year on average.

But that's one single unique time period and shouldn't be expected by long-term investors. And for what it's worth, during that 21-year time span, U.S. stocks outpaced inflation by about 12% per year on average. So even though cash had a positive real return, it was still a fraction of what the equity market delivered during that time period. As always, longer timeframes should help investors set better expectations around their investments.

For the last 95 years, on average, cash under the mattress has returned about 3%, roughly equal to the average rate of inflation during that same time period. In other words, over long periods of time, investors should not expect cash under the mattress to outpace inflation and increase their purchasing power.

And that's the core reason that investors take risk with their hard-earned money and invest it in other asset classes to earn a rate of return above and beyond inflation.

So while I believe investors should be smart with their cash and optimize the dollars that they do keep under the mattress by leveraging treasury money market funds and or high yield savings accounts, I don't think that we should view today's 5% cash yielding environment much differently than in years past. Sure, we might get lucky and catch a short time period where cash returns do outpace inflation or even outperform stocks and bonds.

But now we're hoping that we have a working crystal ball. And personally, I don't think anyone does. Investing is a risk reward decision. If we want to earn healthy, real returns that allow us to reach our retirement goals and or enjoy spending money in retirement without putting our plan in jeopardy, we have to accept a certain level of risk.

We also have to be careful viewing cash as an investment. In the accumulation phase of life, investing money in cash is a sure way to reduce the growth rate of your dollars. Go back to that time period from 1978 to 1999 that I referenced when cash had some of the best real returns in history.

Sure, you outpaced inflation by about 3% each year on average for those 21 years. But the U.S. stock market during that same time period turned $100,000 into $3.3 million. That was a significant wealth building opportunity that most long-term savers just couldn't afford to miss.

On the other end of the spectrum, those who are in retirement viewing cash as a low-risk investment are increasing the chances of running out of money before end of life. A certain rate of return above and beyond inflation is required in order to maintain regular withdrawals and maintain purchasing power over a 40-year retirement.

And I've addressed this before, but one response I often hear is that investing in cash right now or investing in CDs is a bond replacement, that they don't think bonds are a good investment at the moment, so they would prefer to just own cash. The challenge is that cash doesn't produce the returns a retirement investor might need when catastrophic events hit. Just go back to 08-09, the great financial crisis.

From October of 2007 to the bottom of the market in March of 2009, the U.S. stock market was down about 50%. Meanwhile, cash had a cumulative return of about 3%, not bad, but intermediate U.S. treasury bonds during that time period returned 13%. That

That 13% total return from AAA-rated bonds during the second worst recession in history was wildly helpful to a retiree who was taking regular withdrawals from their portfolio to fund their retirement expenses. They would have been able to withdraw money from the appreciation in their bonds, or as we call it, their war chest, while their stocks went on a wild ride for 18 months.

Perhaps another catastrophic event is not around the corner, but if inflation continues to tick down, might we see the Fed reverse course and begin lowering interest rates? If that occurs, which seems plausible based on everything we know today, a three-year bank CD paying us 4% may not look all that appealing compared to the price appreciation that AAA-rated bonds would deliver in that situation.

Now, while I'm comparing these two asset classes in isolation here, it truly is not an either or situation. For those who are in retirement or nearing retirement, a healthy percentage of bonds and cash, despite how each might be performing here in the short term, is required in order to maintain healthy withdrawal rates for multiple decades.

As I've shared before, our rule of thumb is to establish a war chest of cash and bonds that equals two to five years of living expenses in retirement. It might equal two years if you prefer taking a little more risk or you need to take more risk, and it might equal closer to five years if you are risk averse or your plan doesn't require more risk because you've over-saved.

Cash is king. And for those who are in retirement or close to it, a healthy cash balance is absolutely needed to weather unpredictable storms, as the Volvo CEO famously stated. But cash is not an investment. Higher yields are great, except when we compare those higher yields to the rate of inflation. And

And more importantly, higher cash yields should not lure long-term retirement investors into thinking that they can outsmart the markets and achieve a higher return with less risk.

Risk and return go hand in hand. If we want to have a successful retirement plan, if we want to maximize our retirement income while mitigating the chances of running out of money throughout a 40-year retirement, we have to make 40-year investing decisions. Chasing short-term trends, even with an asset class as boring as cash, will only increase our long-term risk.

Once again, to grab the show notes for today's episode, just head over to youstaywealthy.com forward slash 189. Thank you as always for listening, and I will see you back here next week. This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.