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Not long ago, investors were earning virtually 0% returns on cash.
Because the Federal Reserve has kept interest rates high to combat high inflation, you can easily earn 5% annual percentage yields in savings accounts and other low-risk vehicles.
Some experts warn that it’s possible to get too comfortable with those super-safe returns and miss out on the opportunity to earn bigger returns from the market.
“We’re too obsessed with cash,” Callie Cox, chief market strategist at Ritholtz Wealth Management, wrote in a blog post last week.
It is estimated that there is about $6 trillion in cash stored in money market funds.
Industry research shows that younger investors (those with the longest time horizon to absorb risk) are the biggest cash spenders.
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More than half (55%) of young, wealthy investors ages 21 to 43 have increased their cash allocations over the past two years, compared with 46% of those ages 44 and older, according to recent Bank of America research.
While Bank of America focused on investors with at least $3 million in investable assets, trading and investment platform eToro found earlier this year that younger investors are twice as likely as their parents’ generation to have increased their assets in cash. eToro’s survey polled 1,000 U.S. retail investors as part of a larger group of 10,000 across 13 countries, with respondents owning at least one investment product.
“The biggest problem that not enough people are talking about is the fact that younger investors are over-allocating cash because of the allure of the 5% savings rate,” Cox said in an interview with CNBC.com.
“Investing under is a risk, and I think younger investors are more susceptible to it,” Cox said.
The “day of reckoning” may be approaching for savers
Over the long term, a 5% return may not match the potential gains investors can earn from stocks. A more aggressive portfolio allocation to stocks can yield an average annual rate of return of 7%. In some years, that rate will be higher, and in others, lower.
The S&P 500 index could rise to 5,800 by the end of this year, boosting its total return to more than 20% for the year, Thomas Lee, managing partner at research firm Fundstrat Global Advisors, told CNBC’s “Squawk Box” on Monday.
That would follow a 24% return for the index in 2023, he noted, bringing the total for both years to about 50%. That would be “painful” for cash investors who missed out on those gains, as it would take 10 years to achieve the same results, Lee explained.
“I think the end of this year is a day of reckoning for those who said, ‘Oh, I’m happy with my $6 trillion in cash earning 5%,’ when in reality, unless the economy is entering a recession, the expansion could continue for some time,” Lee said.
However, not all experts are so optimistic.
The S&P 500 could fall more than 30% by the end of this year if a recession occurs, research firm BCA Research predicts.
How much cash savings do you need?
Of course, all investors should have some cash set aside, experts say. Financial advisors generally recommend having three to six months’ worth of expenses in cash in case of emergency.
Research shows that many Americans fall short of that goal. According to a recent survey by financial services firm Empower, the average American has just $600 in emergency savings.
Bankrate recently found that of all Americans with cash savings, 67% still earn less than a 4% annual percentage return.
For goals that will be achieved within one to two years, or even three to five years, it makes sense to set aside cash to ensure the money is there when you need it, Cox said.
“But over any period longer than five years, I would seriously consider investing that money in stocks or other riskier assets,” Cox said.
Market timing is a “futile mission”
Fear may be one reason investors are tempted to stay on the sidelines when it comes to cash right now.
But the risk of missing out on the market’s bullish momentum may be the biggest opportunity cost, experts say.
“Market timing is really a futile endeavor, but market non-participation is also foolish, particularly for long-term investors,” said Mark Hamrick, senior economic analyst at Bankrate.
While there’s always the possibility that markets could continue to rise indefinitely or fall 50%, those are the extreme cases, Cox said.
“You might have to wait a long time for that pullback to happen if you just hold cash,” Cox said.
The biggest risk for investors now is missing another leg of this rally, he said.
The environment for cash savings could be about to change, as the Federal Reserve has signaled plans to eventually begin cutting interest rates as inflation declines.
That may make a 5% yield on cash a thing of the past. Savers can lock in five-year certificates of deposit at current rates, Hamrick said. But they should be aware that they will have to pay a penalty if they want to access that money before the five years are up, he said.
“Yields on CDs, high-yield savings accounts, money market accounts and the like will remain elevated,” Hamrick said. “Rates will likely come down, but they won’t fall like a rock, they will fall like a feather.”
