The risks of carrying cash as rates decline

Investing.com -- The surge in money market funds’ assets, which have reached record highs, exposes investors to reinvestment risk as the Federal Reserve shifts towards a rate-cutting cycle.

While holding cash has provided stable returns in recent years, investors may now face diminishing returns as interest rates fall, creating a challenge to reinvest at comparable yields, Wells Fargo strategists noted in a recent report.

Reinvestment risk is a key concern. Investors currently earning nearly 5% on cash positions in money market funds might struggle to find similarly low-risk options with equivalent yields as rates continue to drop.

When talking about the long run, a different risk arises – the cash drag on portfolio performance. Historically, riskier assets like equities have significantly outperformed cash. Wells Fargo’s analysis highlights that $1 million invested in small-cap equities in 1926 would have grown to $62 billion, while the same investment in Treasury bills, a common cash alternative, would have reached only $24 million over the same period.

“On a risk-adjusted basis measured by the Sharpe ratios, our long-term capital market assumptions study shows that U.S. equities have beat cash returns over the long term,” the report says.

“The power of compounding returns has generally benefited riskier assets like equities while leaving cash in a disadvantaged position for long-term investors. Therefore, we caution investors to avoid cash as a long-term investment strategy or significant allocation.”

For investors reconsidering their cash-heavy portfolios, Wells Fargo advises diversification across asset classes to balance risk and return.

While it may be tempting to shift aggressively into higher-risk assets, the report suggests that a strategic reallocation, such as dollar-cost averaging into a diversified portfolio, can provide growth potential while mitigating risk. This approach can help investors navigate the risks associated with declining interest rates while positioning for long-term financial goals.

The stock market has witnessed significant volatility over the past few months. The S&P 500 Index dropped from around 5670 to 5150 between July and August, before climbing back up to near 5650 by the end of August.

It then fell to approximately 5400, followed by a recovery to all-time highs. This volatility has been largely driven by a battle between concerns over a potential recession and hopes for a soft landing.

Contributing factors include a slowing economy, shifts in monetary policy, and the upcoming elections. Some are now questioning whether an economic or earnings recession is coming.

However, Wells Fargo strategists believe the current outlook suggests a mild slowdown rather than a full-blown recession, with a recovery expected by late 2025.

Source: Investing.com