Investors in today’s market have been enjoying the luxury of earning 5% annual percentage yields on savings accounts and other low-risk vehicles, thanks to the Federal Reserve’s efforts to combat high inflation. However, experts are now cautioning against becoming too comfortable with these super-safe returns, as it may cause investors to miss out on the potential for higher returns from the market. A significant amount of $6 trillion is currently parked in money market funds, indicating a growing trend of investors favoring cash over riskier assets.
Recent research from Bank of America revealed that younger investors, with the longest time horizon to absorb risk, are increasingly allocating more of their portfolios to cash. In fact, 55% of wealthy younger investors between the ages of 21 to 43 have ramped up their cash allocations in the past two years, compared to 46% of individuals ages 44 and above. This trend is further supported by a survey conducted by eToro, which found that younger investors are twice as likely as their parent’s generation to have increased their cash assets, indicating a significant generational gap in investment strategies.
The appeal of a 5% savings rate has been a driving factor behind the increased allocation to cash among younger investors. However, as Callie Cox, chief market strategist at Ritholtz Wealth Management points out, under-investing in riskier assets poses a long-term risk to investors. While a 5% return may seem attractive, it can fall short of the potential gains investors can achieve through a more aggressive allocation to stocks, which historically yield an average annual rate of return of 7%.
Market experts warn that investors who remain over-allocated in cash may miss out on substantial market gains. The S&P 500 index is projected to climb to 5,800 by the end of the year, bringing its total return to more than 20%. This significant growth in the market could be “painful” for cash investors who fail to capitalize on these gains, as it would take them significantly longer to achieve comparable results through cash investments.
While holding cash for emergencies is essential, financial advisors recommend maintaining at least three to six months’ worth of expenses in cash. Research shows that many Americans fall short of this goal, with a median emergency savings of just $600. For short-term goals, allocating cash makes sense to ensure the money is readily accessible. However, for long-term investments beyond five years, it may be more prudent to consider riskier assets like stocks for higher potential returns.
Fear and market timing are common reasons why investors may choose to remain in cash. However, experts caution that the risk of missing out on market upside may be a more significant opportunity cost. While there is always uncertainty in the market, waiting for a pullback while sitting in cash may result in missing out on potential gains. The biggest risk for investors is failing to capitalize on another leg of the market rally, especially given the current economic climate.
It is important to note that the environment for cash savings may be undergoing a shift, as the Federal Reserve plans to cut interest rates amid subsiding inflation. This could potentially mark the end of the era of 5% returns on cash investments. Savers looking to lock in rates through certificates of deposit should be aware of penalties for early withdrawal. While yields for CDs, high-yield savings accounts, and money market accounts are expected to remain elevated, investors must carefully weigh the trade-offs between liquidity and returns.
While cash serves as a vital component of a well-diversified portfolio, being over-allocated in cash can pose significant risks to long-term investment goals. Investors should consider striking a balance between safety and growth by diversifying their portfolios and exploring riskier assets to maximize their potential returns in the market.