Understanding How Cash Fits Into Your Investment Portfolio
- Chris Harris, CFP® , FMVA
- Jul 17
- 5 min read
It seems like investors have been hit with uncertainty from every direction during the first half of the year, from the war in Iran and concerns about an AI bubble to persistent inflation and the possibility of higher interest rates.
With so much uncertainty, I thought it would be fitting to discuss the role cash can play in a well-constructed, diversified portfolio.
The legendary baseball player Yogi Berra once said that "a nickel ain't worth a dime anymore." With inflation still elevated, many investors and everyday consumers may be relating to this sentiment. Not only have everyday costs risen due to higher energy prices, but short-term interest rates have also declined over the past two years.
This means that investors holding a large portion of their savings in cash are watching the buying power of that money shrink, both as prices go up and as the returns on cash fall. With money market fund assets near record highs at $7.9 trillion, it is likely that many investors are holding more cash than makes sense for their financial plans.1 So, what should investors understand about the role of cash in their portfolios right now?
Managing cash requires careful planning
Cash serves many purposes in both everyday life and in a financial plan, which makes it a more complex topic than it might seem at first. Holding too much of it, however, carries real long-term costs. These costs are easy to miss because cash feels safe, especially when compared to the daily ups and downs of the stock market. But history shows that keeping too much in cash can slow down the growth of wealth over time, since cash does not grow or compound the way stocks, bonds, and other investments do.
In investing and financial planning, the word "cash" is often used to describe any short-term, easy-to-access account or investment. Common examples include savings accounts, money market funds, certificates of deposit (CDs), and similar options. These serve real and important purposes, such as covering near-term expenses, building an emergency fund, saving for a home down payment, or setting aside money for tuition. All of these are valid and necessary uses of cash in a financial plan.
The question is not whether to hold cash at all, but rather how much is appropriate given a person's goals, time frame, and overall portfolio. Holding too much cash is sometimes called having "cash on the sidelines," meaning that money is sitting idle instead of growing, earning dividends, or collecting interest from bonds.
As the chart above shows, money market fund assets have remained at record levels after rising alongside interest rates a few years ago. Higher short-term interest rates can look appealing, especially when the stock market feels uncertain. However, because these rates are short-term, they are not locked in. This creates what investors call "reinvestment risk," which is the possibility that when a short-term account matures, the new rate available may be lower. In order to keep up with inflation and meet financial goals, cash needs to be put to work in investments with stronger long-term potential.
This is especially relevant today, since short-term rates have already started to fall. Investors who moved into cash not only face lower returns now, but most likely also missed a significant portion of the broader market gains seen over the past few years.
Inflation quietly erodes the value of cash
A common misconception is that cash is completely risk-free. While the dollar amount in a bank account does not move up and down the way stock prices do, the true value of that cash can still decline. This is because the value of cash is really about what it can buy, and inflation gradually reduces that buying power over time. The effect may seem small in any single year, but it adds up over many years unless interest payments or investment growth make up the difference.
As the chart above illustrates, the inflation-adjusted return on cash, measured using current CD rates from the FDIC, has been negative for most of the past two decades.2 In plain terms, even when cash appeared to be earning some interest, inflation was rising faster. With headline inflation currently at 4.2% and the one-month Treasury yield at 3.7%, real cash yields (meaning returns after accounting for inflation) remain negative by many measures today.3
Money market funds, savings accounts, and short-term CDs also need to be regularly renewed as they come due. This ongoing reinvestment process is not only something that requires active management, but it is also influenced by changing market and economic conditions. As a result, many of the same forces that affect stocks and bonds also end up affecting the returns on cash.
Stocks and bonds support long-term growth
Stocks and bonds have traditionally formed the foundation of investment portfolios because they can provide both long-term growth and income. Dividend-paying stocks, for example, can offer regular income along with the potential for the investment to grow in value over time. While dividends are not guaranteed the same way bond interest payments are, certain sectors of the S&P 500, such as Real Estate, Energy, and Utilities, currently offer yields above 3%, which is comparable to many shorter-term cash and bond options.
Choosing bonds with longer maturities (meaning they take longer to come due) can also lead to more attractive interest rates. For instance, the 2-year Treasury yield is currently around 4.2%, which is notably higher than short-term cash yields and also matches the latest inflation rate. Investment grade corporate bonds, which are bonds issued by financially stable companies, currently yield 5.3% on average, compared to a historical average of 3.9%. The Bloomberg U.S. Aggregate Bond Index yields 4.8%, which is more than one and a half times its average since 2009. Unlike cash, bonds can also increase in value, and they can help balance out other parts of a portfolio.
Ultimately, history shows that a portfolio with a well-chosen mix of investments can not only keep pace with inflation over time, but can also grow in ways that help support long-term financial goals. This is not a reason to avoid holding cash entirely, but rather a reminder that the purpose of cash in a portfolio is to cover specific, near-term needs. For investors who have built up extra cash over the past few years, it is worth thinking carefully about how to put that money to work in a way that aligns with their broader goals.
As always feel free to reach out with any questions.
Hoping you are enjoying Summer.
References
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Examples are for illustrative purposes only. All investing involves risk of loss including the possible loss of all amounts invested.
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