Mon 23 Oct 2006
Cash is king, but for how long?
Posted by Steve under Money
As an asset class, cash hardly excites. You’ll never overhear two people at a cocktail party talking about cash with the same fervor as the latest flavor of the week tech stock. “Yeah, Jim, my cash portfolio is up 3% this year. At this rate, I’ll be able to retire in 2150.”
But cash and cash equivalents certainly have their places in most portfolios, especially those in retirement seeking income and not growth. Lately, cash has found its way into even more portfolios, replacing spaces usually reserved for bonds. Web savvy investors had taken advantage of online savings accounts yielding 5% and up–higher than the 10-year treasury note. And with inflation running around 3%, a 2% to 2.5% real return on a fully liquid risk-free investment is nothing to sneeze at. Yes, it’s been a good year for cash.
But how long will it last? With the Feds rate hiking campaign on pause for right now and a possibility of rate cuts in the coming year, Cash returns could be coming back down. We’ve already seen signs of it with some online savings accounts reducing yields on savings and CDs. Popular Emigrant Direct recently dropped from 5.15% to 5.05% and Citibank’s 6-month CD has dropped from 5.5% to 5.25%.
So, is the party over? Well, the good news is that there are signs that inflation is easing. Even if cash returns start falling below that of bonds, lower inflation rates could leave real returns unchanged. Of course, it’s a mixed bag when it comes to inflation indicators as there are also signs that inflation is not easing and could actually be accelerating. It will certainly be something to watch in the coming months.
Either way, while cash has had a nice run of late, it should never comprise a majority of a portfolio’s holdings. Even those seeking income investments and low volatility should have a majority of their assets in bonds. Cash is great for those saving for short-term needs, such as a down payment on a house, a new car, a vacation, etc. That cash is currently yielding as much as bonds is something to be enjoyed while it lasts, but not counted on for the future.
Further reading: It’s a Good Year for Cash
October 25th, 2006 at 3:48 pm
Cash is not returning a real rate of return in excess of inflation; you are neglecting the tax effect.
If you assume an effective state/federal rate of 33%, the 5% nominal return on cash is really more like 3.3%, which is basically the rate of inflation.
Because we’re in a high tax bracket, tax-free NY munis are a good buy these days for us (i.e., Vanguard is returning around 3.5% on its NY tax-free MMF).
October 25th, 2006 at 4:05 pm
Not exactly. The real return of an asset is the nominal return less the rate of inflation. You’re describing the after tax real rate of return.
However, I do agree with you that you should always consider tax implications on any investment. Also, living in California, I’d agree that muni funds are definitely worth a close look.