If you’re investing for the long term, you may be facing a common challenge today: what to do with your cash as interest rates on savings accounts and similar products decline. While cash might feel like the safest option, keeping too much of it can actually hurt your ability to reach your financial goals over time. This matters now more than ever, as many investors are sitting on what’s called “cash on the sidelines” – money that’s not invested in stocks or bonds. In fact, money market funds (which are similar to savings accounts) now hold a record $7.3 trillion.
Investing isn’t about choosing between risky investments and cash, or trying to guess the perfect time to buy and sell. Instead, it’s about finding the right balance of different types of investments that match your long-term plans. Cash definitely has its place in these plans, particularly for paying your bills and having money set aside for emergencies.
But when investors keep more cash than they really need for these purposes – what some call “excess cash” – they may be missing chances to earn income, grow their money, manage risk, and achieve other important goals. So in today’s market, how can you make the best use of cash in your investment portfolio while still working toward your long-term objectives?
Over long periods, stocks and bonds have grown faster than the cost of living
When we look at the history of financial markets, one thing becomes very clear: stocks and bonds have been effective tools for growing savings and staying ahead of inflation (the rising cost of goods and services). The chart above shows that stocks and bonds have increased in value far more than inflation has risen. Even though something that cost $1 in 1926 now costs $18 today, stocks and bonds have grown by much larger amounts, helping create real wealth for investors who stayed invested through these long-term trends. This happened even though there were market downturns, financial crises, and economic recessions over the past hundred years.
While past results don’t guarantee future outcomes, this year’s market recovery demonstrates how quickly negative sentiment can turn into positive returns. Even the higher inflation we’ve experienced in recent years has been small compared to the returns from a mix of stocks and bonds. When you look at the long term, even modest returns above inflation can build wealth through the power of compounding (when your returns generate additional returns over time).
From a financial planning standpoint, cash serves important purposes. It provides ready access to money for near-term expenses and emergencies. For example, if you’re saving for a down payment on a house you plan to buy soon, you’ll likely want to keep that money in cash or cash-like investments. The same goes for tuition payments and other bills you need to pay within the next year. Having an emergency fund also offers crucial protection against unexpected situations like losing your job or facing medical bills.
Keeping too much cash slowly reduces what you can buy with your money
The issue arises when investors hold more cash than they need for these practical purposes. This has been easy to understand over the past few years because of uncertain markets and attractive interest rates on cash. When the interest you can earn on cash is high compared to what bonds pay or what you might receive in stock dividends, it can seem sensible to keep money in cash since it appears to be “risk-free.” However, this approach comes with at least two hidden costs.
The first hidden cost is inflation. Even when the interest rates on savings accounts or money market funds look reasonable, or start out attractive, they often don’t keep up with rising prices year after year. The chart here shows that the real income from cash (after accounting for inflation) has actually been negative throughout most of the past twenty years when looking at typical certificate of deposit rates.
The second hidden cost relates to how short-term interest rates behave. While the returns on money market funds, short-term certificates of deposit, and savings accounts may look appealing – especially compared to the very low rates we saw in the decade following the 2008 financial crisis – these rates aren’t permanent. By their nature, they’re short-term and can change. So while some starting rates can be quite attractive, these rates can vary and need to be watched carefully as they reset.
Generally speaking, the fact that cash and short-term bonds need to be reinvested at whatever rates are available at the time creates something called “reinvestment risk.” For instance, if the Federal Reserve (the central bank that influences interest rates) continues lowering rates as many experts expect, short-term interest rates could keep falling, potentially earning less than the rate of inflation. When this happens, investors must decide whether to accept lower returns each time their investment matures or move back to longer-term investments. Since longer-term investments typically increase in price when rates fall, investors might be missing out on gains in the meantime.
The situation differs significantly with longer-term bonds, where you can lock in interest rates for years or even decades. An investor who buys a 10-year Treasury bond (a government bond) today secures that interest rate no matter what happens to rates in the future, even though the bond’s market price may fluctuate. Similarly, while the stock market always involves uncertainty, investing with a long-term perspective has historically helped investors achieve growth over time without facing constant reinvestment risk.
Cash feels safe because the number you see in your account balance stays steady, even when markets are uncertain. However, what truly determines financial security is what we can purchase with our money, not just the dollar amount in our accounts. If inflation runs at 3% per year while cash earns 2%, the buying power of those savings decreases by 1% each year, even though the account balance might look unchanged. This seemingly small gap can grow substantially over time and significantly impact financial goals that span decades, particularly for people in retirement.
The amount of uninvested cash has reached historic highs
Cash isn’t only about individual financial plans – it also tells us something about the overall market. The chart here shows that money market fund holdings have reached near-record levels of $7.3 trillion, almost twice the amount held before the pandemic. This reflects both investors seeking higher short-term interest rates and reluctance to invest in longer-term options.
However, as rates have started to moderate and are expected to fall further, these large cash holdings could face reinvestment challenges. Investors who shifted substantial assets to cash when rates were temporarily high, or during times of market stress, may face tough choices. This is often called “cash on the sidelines,” referring to the possibility that some investors may gradually move back into stock and bond investments over time.
The best way to handle excess cash depends on your specific goals but might include strategies like dollar-cost averaging (investing equal amounts at regular intervals over time). This matters today as the stock market continues its upward trend and bond interest rates remain appealing. The income from longer-term Treasury bonds, corporate bonds, high-yield bonds, and other fixed income investments is still attractive compared to historical levels. And while interest rates are hard to predict, bond market ups and downs have stabilized. The same applies to the stock market, which has exceeded expectations this year.
The bottom line? While cash has important uses, keeping too much creates hidden costs. For long-term investors, maintaining an appropriate cash reserve while staying invested in long-term portfolios remains the best approach to reaching financial goals.
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Investing involves risk, including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. None of the information contained on this website shall constitute an offer to sell or solicit any offer to buy a security or any insurance product.
Any references to protection benefits or steady and reliable income streams on this website refer only to fixed insurance products. They do not refer, in any way, to securities or investment advisory products. Annuity guarantees are backed by the financial strength and claims-paying ability of the issuing insurance company. Annuities are insurance products that may be subject to fees, surrender charges and holding periods which vary by insurance company. Annuities are not FDIC insured.
The information and opinions contained in any of the material requested from this website are provided by third parties and have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed. They are given for informational purposes only and are not a solicitation to buy or sell any of the products mentioned.
