Given that U.S. short-term interest rates are stuck at zero, and are likely to remain unusually low for some time even if the Federal Reserve starts to raise rates later this year, return for cash this year is almost certain to be negative. The only potential exception would be if the U.S. enters a deflationary environment. Help cushion volatility with bonds.
Market Realist – Needless to say, cash is important for a portfolio, especially considering the current rich valuations in the market and the possibility of heightened volatility (VXX). However, your stock of cash might need a little help. There are some definite disadvantages to holding cash.
Reserves of cash, if kept idle, lose their value over time. A pure cash portfolio means negative returns over the long term as inflation erodes the purchasing power of your reserves.
The above graph shows the compounded annual returns of cash, stocks (as represented by the S&P 500) (SPY), and bonds (TLT) after taxes and inflation over the period from 1926–2014. Equities have posted the strongest performance, yielding a total return of 10.1% over the period. The figure after taxes and inflation for equities comes in at a good 4.4%. Cash, on the other hand, has registered a total return of only 3.5%, and the statistics after taxes and inflation come in at a woeful -0.8%. This is indeed a matter of concern, as the negative gains do not bode well for any of your financial goals.
Taking money out of the stock (IVV) or bond markets (IEF) involves an opportunity cost. Investors would lose the possible gains they could have enjoyed had they stayed invested in the markets. Over the long term, cash is a losing bet, and sometimes even a riskier one than a well-diversified portfolio composed of stocks and bonds (BND). Holding cash for the purpose of timing the market might not be a great idea if an investor lacks the discipline required to enter and exit when a red flag goes up. Investors might miss opportunities if they stay out of the markets for very long.
Read on to the next part of the series to understand how you can help counter volatility with investments in bonds.