In the years following the 2008 financial crisis, stocks experienced a prolonged bull market, generating positive returns for several years. Those returns were high enough to draw many investors to the equity markets. This, coupled with the low interest rates offered on savings accounts, drew more investors toward stocks.
However, stock markets have turned downward in 2022, changing the calculation about the relative attractiveness of investing in equities vs. keeping money in cash. As the Federal Reserve raises interest rates in an effort to combat inflation, cash becomes more advantageous, as the interest you earn on your cash holdings ticks upward along with the rate increases. At the same time, increased interest rates could slow economic growth or even sink the economy into a recession, raising questions about future stock returns.
Let’s take a look at some of the important risk factors to consider when investing in cash vs. stocks and managing risk optimization.
Key Takeaways
- Stocks had a great run over the past decade, while the rates offered by savings accounts remained dramatically low, drawing investors toward riskier investments in search of yield and returns.
- However, the calculation has changed in 2022, with interest rate hikes by the Federal Reserve making cash investments more attractive and raising doubts about future stock returns.
- Investors must consider volatility and current interest rates when deciding how much to invest in cash vs. stocks.
- For investors looking to gain exposure to stocks during periods of market volatility, one advisable strategy is dollar-cost averaging (DCA) into index funds.
Things to Remember About Stocks
The stock market ebbs and flows, with periods of ups and downs, bull runs and bear slumps. Granted, there have been a lot more ups than downs over recent decades. For instance, the S&P 500 was up about 195% for the 10-year period ending Oct. 9, 2020—or an annualized 11.4% return.
However, the stock market bonanza of recent years has not managed to hold strong in 2022. As of Oct. 13, 2022, the benchmark S&P 500 index was down more than 24% year to date, with a decline in excess of 20% indicating that the market has entered bear market territory.
As the recent declines in the stock market make clear, it is difficult to predict which way the market will go. Therefore, market timing is ill-advised. Because stock prices have trended upward over the long term, the general advice is that it is more profitable to remain invested in stocks, even in periods of market turmoil, rather than pulling out of those markets entirely.
Investors can also allocate money to index funds via dollar-cost averaging (DCA) instead of keeping cash on the sidelines. Sticking to this strategy when markets are down means acquiring shares at a lower price and increasing the opportunity for gains when markets recover.
Even investors will likely be better off over the long term if they avoid overreactions to downturns in the stock market. One of the keys to growing a portfolio is minimizing losses. Market timing with cash and strategic stock purchases can be vital to keeping your losses as low as possible.
Key Considerations for Stock Investors
Volatility
Volatility is a key factor when investing in stocks. In other words, how quickly or severely do prices whip around? High volatility can cause investors to panic-sell. Monitoring stock volatility can be more than many investors want to handle on a daily basis.
Monetary Policy
Monetary policy is another factor to follow, along with volatility. It can greatly influence the market’s investment demand and how investors allocate their money. Setting interest rates low helps to stimulate borrowing, while higher rates cause more investors to save. However, low rates translate into lower rates for savings accounts and fixed-income investments.
In 2015, the Federal Reserve raised the federal funds rate for the first time in seven years, finally lifting it to 0.25% from 0%. Then the federal funds rate range set by the Fed increased from 0.25% to 0.50% that same year, eventually reaching a level of 2.25% to 2.5% by December 2018. However, concerns about the economy during the COVID-19 pandemic caused the central bank to lower rates yet again, with the fed funds rate dipping back to the 0%-to-0.25% range in March 2020.
The low-interest-rate environment maintained by the Fed throughout the peak of the pandemic made stocks an attractive investment compared with keeping money in cash. However, as inflation concerns took center stage in 2022, the Fed began a steady series of rate increases, with the federal funds rate rising to a range of 3% to 3.25% in September 2022.
These boosted interest rates have a multifaceted impact on those considering how much of their portfolio to invest in stock and how much to allocate to cash. Higher rates make cash investments more profitable, as the interest paid on savings account deposits and other cash equivalents increases. Furthermore, the increased rates mean that it is more costly for companies to borrow to fund their expansion and growth, potentially limiting returns for stock investors.
Corporate Profitability
Corporate profits can transfer directly into stock prices. While companies have generated strong profits for several years, the pandemic may have put some strain on corporate profits.
The lingering effects of the pandemic and the additional geopolitical instability related to the war in Ukraine could have a continued impact on corporate profits over the coming quarters and years. A slowdown in the growth of corporate profits could lead to lower stock prices over a longer term.
Alternatively, many of the global international companies are also top dividend payers, which affects income investors deciding between stocks and cash as well.
Cash vs. Stocks
Investors deciding whether to invest in stocks or hold cash will need to keep a close eye on interest rates. One of the downsides of holding cash is that the buying power of your money slowly deteriorates due to inflation. In late October 2022, the rates being paid on savings accounts and Treasurys are not keeping pace with high levels of inflation.
The 10-year Treasury rate as of Oct. 28, 2022, was 4.02%. Meanwhile, the inflation rate for the 12 months ended September 2022, as measured by the Consumer Price Index for All Urban Consumers (CPI-U), was 8.2%. One of the big issues for cash investors these days is that, while interest rates have been moving steadily higher, they remain below elevated inflation rates.
That said, below are some additional considerations for cash vs. stocks in 2024 and beyond.
- Are company profits growing or stable? Many investors may consider certain companies to be a great buy because their stock prices have fallen. But buyer beware—the market may not stabilize and improve as fast as some expect.
- Do the dividends currently being paid have stability? Dividends are a large portion of the total return you get on a stock. If a company has a solid dividend-paying history and a relatively low payout ratio, then you might consider buying it.
- Are stocks safe to own for the next five years, given the current market conditions? In other words, do you have enough conviction in the stock’s value or growth prospects to believe in its ability to weather the market’s volatility?
The amount of money you are willing to invest in cash vs. stocks will also be influenced by your risk tolerance and investing goals. Investors who need funds for emergencies or are saving for high-ticket purchases will want to invest more in cash. Investors with greater risk tolerance and longer-term horizons for investing can put more money toward stocks.
How Much Should I Invest in Cash vs. Stocks?
In addition to your appetite for risk and the level of returns you are hoping to achieve with your investments, current market conditions can have implications for the ideal breakdown between cash and stocks in your portfolio. In periods of economic growth and low interest rates, stock prices generally climb, and the amount you can earn on cash investments remains limited. However, when interest rates increase and the prospects for economic growth become less certain—as has been the case in 2022—savings accounts and cash equivalents become more attractive.
How Do I Determine the Best Asset Allocation for My Portfolio?
The asset allocation that works the best for you depends on many factors, including your time frame and your tolerance for risk. Determining the optimal asset allocation strategy involves finding the right mix of investments—from most aggressive to safest—that will earn the returns you need with comfortable levels of risk.
For most investors, the ideal mix mostly includes stocks, bonds, and cash or other money market securities. Just as there is no one-size-fits-all strategy, keep in mind that asset allocation is not a one-time decision, and it’s important to review your strategy periodically to ensure that it remains in line with your goals.
What Are Cash Investments?
If you are hoping to preserve your capital and invest with a low level of risk, you may opt for secure investment vehicles such as cash investments. A cash investment is a short-term obligation, usually fewer than 90 days, that provides a return in the form of interest payments.
Examples of cash investments include money market accounts (MMAs) and certificates of deposit (CDs). Market conditions such as high interest rates increase the relative attractiveness of cash investments, and investors may also choose to allocate money temporarily to cash investments while researching other investment products.
The Bottom Line
Where the stock market or economy is headed, and at what pace, will vary based on the investment advice you follow. The current market environment—with interest rates on the rise and doubts about the near-term prospects for economic growth—increases the attractiveness of allocating portions of your portfolio to cash compared with riskier investments in the stock market.
However, it is best to avoid overreacting to market volatility by pulling your investments entirely out of stocks. The tendency for stocks to gain in value over the long term suggests that there is an advantage in maintaining exposure to the equities market—provided you have the risk tolerance and a long-enough investment time frame to weather the ups and downs while waiting for the market to recover.
Read the original article on Investopedia.