In today’s environment of ultra-low interest rates and high inflation, holding cash for an extended period of time can seem foolish. In any given environment, there is always something that is making more money than cash. For this reason, it is typical to hear the saying “cash is trash” being thrown around by investors. However, this isn’t necessarily a consensus view, and opinions on holding cash can vary quite a lot. Of course, you should always have enough cash in case of an emergency, usually 3-6 months living expenses is sufficient, and you should also hold cash for any spending goals that are approaching in the next year or two. Going further out than a year or two, there starts to be some disagreement on whether you should hold cash or not.
We can get a bit of perspective if we study some of the most famous investors and their views on holding cash. Warren Buffett, perhaps the most famous investor of our era, is known for often holding a large portion of cash in his portfolio. He is willing to sit on cash for a long time until he finds an investment that meets his standards. Essentially, it comes down to him being extremely selective about his investments. While he recommends others invest in index funds, that isn’t something he does with his own money. Warren Buffet’s last Berkshire Hathaway holdings report, for example, shows that he has about $370 billion invested in various companies and $106 billion sitting in cash. This is a more than 20% allocation to cash, which is much more than what most people have allocated to cash. When an opportunity presents itself, he’ll have more than enough dry powder to deploy.
Howard Marks, also a famous investor but not quite as well-known as Buffett, has a very different philosophy. He has mentioned several times that he never allocates to cash, at least in his investment strategies. He believes that you pose a big risk of losing out on returns if you are holding cash. This view is shared by many other famed investors. The idea is that there is always something that will generate a return even in the worst market crashes. You just have to find what investment that is.
So, who is right? Well, there’s no clear correct answer for this, but let’s look at the dynamics of holding cash. First, we should recognize that cash is not as risk-free as it seems. Excluding fraud, you can expect that your cash won’t go down in value, which makes it seem risk-free, but it can lose purchasing power. In an inflationary environment like we’re in now, this is a notable risk. If inflation remains elevated above 5% for the next few years, cash holders that could buy a $50,000 car today may end up having to settle for a cheaper car several years from now.
If we leverage the wisdom of these famous investors in conjunction with the risks of cash, we can conclude that holding cash in place of other investments can be useful at times when you are searching for better opportunities, but when you hold cash for too long you have a risk of missing out on returns and of losing purchasing power. With this in mind, I believe that ultimately you should not hold cash for longer than three to five years, and during that time you should be searching for investment opportunities. Inflation is rare, but when it occurs, we have seen that it can happen fast, and it can be higher than anyone expects.
So, this brings us to the question of – what should you do with your cash while you are waiting for that opportunity? Well, I have three main ideas for how to best manage your cash:
The first idea does have liquidity constraints, but given the inflationary environment we are in now, I bonds have become a very attractive place to park some cash. The return you get from an I bond is the combination of a fixed rate plus an inflation increase. With inflation as high as it is now, I bonds are paying a 9.6% interest rate through October. This is an exceptional return. Unfortunately, there are some limits. Each person can only buy $10,000 worth of I bonds each year. The liquidity constraint is that you must hold the I bond for at least a year, so for some that may be too much of a liquidity constraint. Additionally, if you cash them out in less than five years, you will have to give up the last three months of interest accrued. If you don’t mind the downsides, these are a great option for most people.
If you want a fully liquid place to park your cash but don’t mind decreased return, floating rate treasuries can be a good option. You can invest in floating rate treasuries directly or through a fund that holds them. Their interest rate floats to the 3-month treasury bill rate on a weekly basis, so there is almost no interest rate risk. Right now, the interest rate of floating rate treasuries is about 2.7%. This is a lower rate than what you would get on an I bond, but for a fully liquid investment with very little risk, it is pretty attractive.
If you don’t mind taking on a little bit more interest rate risk and you want your cash to be liquid, US treasuries up to the 3-year maturity can be a good place to park cash. 3-year treasuries have about a 3.3% yield right now. This is a little bit higher than what floating rate treasuries offer, but you will be taking on a little bit more interest rate risk. If interest rates move up sharply, they could lose value, but if you don’t go further out than the 3-year treasury, any losses will be relatively minimal. For those that prioritize liquidity and don’t mind slightly more interest rate risk, this could be an attractive option.
There are other options as well, like money market funds or other short-term debt instruments, which could be a good option, but you’ll notice that one overarching theme of each of the ideas I highlighted is that they are US government backed securities, so they’re the safest investments out there. Some investors like to reach for a higher yield with commercial paper or other short-term investments, but you’ll be taking on a little bit of credit risk when you do that, and as Warren Buffett has said, “reaching for yield is really stupid.”
Over the long-term, with inflation constantly eroding purchasing power, cash is trash, but it can be useful in the short-term. Plus, if you are smart about how you hold cash, you can mitigate much of the impact of inflation.
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