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Cash is King?

Published by: Chris Kittrell Date: January 29, 2012

The “cash is king” behavior many investors now embrace stems from the fear many experienced in late 2008 and early 2009 when the global markets dove into what, at the time, felt like the abyss. Investors just wanted the fear and pain to stop. Money flowed out of equity mutual funds and found a home in savings accounts, money market funds and cd’s. The pain ceased. Sleep was, again, attainable. Account statements no longer showed losses every month. One of the results of this market volatility was investors desire to hold more cash in their investment portfolios than normal. But at what price to an investor?

Since the onset of the financial crisis in late 2007, the Federal Reserve has used interest-rate cuts and other policy tools in an effort to fuel economic growth. Economists can debate the effectiveness of these policies, but everyone can agree that today’s low interest rates are a two-sided coin.

Consumers, businesses, and government all benefit from low borrowing costs. But on the other side, savers and investors earn almost nothing on their cash balances. This has been the case in most months since 2008, when the Fed cut short-term interest rates to near zero. Worse yet, investors are actually losing wealth in real terms. The inflation-adjusted yields on short-term Treasury securities have been negative in most months since October 2010.

Negative real yields have occurred during periods of high interest rates (early 1980s) and during periods of low interest rates (2010–11). Regardless of the scenario, negative real yields cause investors to lose purchasing power.

Negative real yields during recessionary periods, when the Fed is cutting interest rates to spur a recovery, can be the most dangerous and confusing for investors. These times are when investors are most tempted to flee the capital markets for the perceived safety of cash. Investors have a host of reasons for their flight—some might want to avoid economic uncertainty or stock market volatility, while others might fear that impending interest rates increases will cause bonds to lose value.

This is the case for many individual investors today. They have shifted their portfolios to money market funds and other cash instruments with the intent to return to stocks and bonds when the economy shows signs of improvement. The problem with this strategy is that no one can consistently time markets, and the signs are never clear. So while investors sit in cash, their purchasing power quietly erodes.

Chris Kittrell is co-founder and a Senior Financial Advisor with Rather & Kittrell.  He is available at ckittrell@rkcapital.com