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What To Do With Your Cash Holdings

Lately, I've gotten a number of questions from people who are frustrated by the low returns on their cash holdings. Getting 0.30% in a money market fund or in a short term CD isn't that exciting. So there's a temptation to seek higher returns on cash, but that could open you up to some surprising outcomes.
Returns Aren't That Bad. First, the returns on cash aren't as bad as they appear. In fact, if you look at what's called the "real return", it's about par for the course. Real return means the return you get on your money after you net out inflation. This is the return that tells you if your money is actually growing from a purchasing power standpoint.
  • For instance, if inflation is 2 percent and you get 3 percent in your money market fund, your real return is 1 percent.
  • Over the last 80 years or so, the return on cash equivalent holdings has basically outpaced inflation by a little less than 1 percent. According to Ibbotson Associates, since 1926, U.S Treasury Bills have provided a 3.7 percent return and inflation ran at 3.0 percent, for a 0.70 percent real rate of return.
Well, if you're getting 0.30% percent in a short term CD today, there's no way you can have a 0.70% real return. Right? Not so. Why? Because inflation has been negative over the last year. The latest CPI data shows inflation at -1.3 percent from May 2008 through May 2009. If inflation was -1.3 percent, and you got 0.30 percent on your cash, you actually had a 1.6 percent real rate of return, which is pretty good historically.

I expect the negative CPI figure will be short-lived, but basically what this tells you is that the returns on cash aren't out of line, given how weak the economy is. Instead of being frustrated, if you view it from a real return standpoint, the numbers are fair. But, there's the temptation to seek more yield because the rates seem so low.

Little Return, Big Risks. Unfortunately, by seeking just a little more return on cash, you may open yourself up to big declines. Last year, a number of well known mutual fund holdings that were marketed as cash equivalents fell by 20 percent or more. These were funds that were marketed as "yield plus" or "yield enhanced" funds. But to get a higher yield, these funds had to own riskier securities. And when the credit markets collapsed, so did the value of these funds. Basically, by seeking an extra 1 percent return, some investors ended up losing 20 percent. Not a great trade-off.

In fact, much of the banking crisis is rooted in banks seeking just a little more return on certain types of securitized mortgages. By reaching for more return, they opened themselves up to complete destruction.

There's A Reason. Today, I'd be very careful about seeking more yield on your cash. There's a reason short term rates are so low and I wouldn't ignore it. The markets are either pricing in more deflationary pressure, in which case the real returns are pretty good; or they're waiting for the next shoe to drop in the global economy, in which case holding stable cash will be worth it.

Bottom line. When it comes to cash, the rule is stability first, return second. With low (or no) inflation, the current returns aren't as bad as they appear. You may need to be satisfied with that for the time being.

As with all financial matters, consult your individual advisor prior to making any financial decisions.

Photo from Flickr, courtesy of alancleaver, CC 2.0

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