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Dear Clients and Friends of Cornerstone:

Managing our money used to be a simple process.  We deposited cash into our checking, savings, or money market accounts and earned a respectable amount of interest.  Those days are long gone.  The Federal Reserve policies have kept cash instrument yields in the 0 to 1% range for years.  This month’s article discusses 5 mistakes to avoid when investing in CDs, money markets, and savings accounts.  Higher yields may be attractive but they might expose you to more risk and less liquidity than you truly want or need.

If you would like to refer back to any previous newsletters we have published, you can find them on our website. Please be sure to visit www.ccadvisors.com.

– Cornerstone Capital Advisors

5 Mistakes to Avoid With Your Cash Holdings

With yields seemingly as low as they can go, you don’t have to go far to run into trouble

By Christine Benz | 08-25-16 | 

The Federal Reserve’s zero-interest-rate policy has had an uplifting effect for stocks and bonds, while cash-holders have gotten crunched. After all, if you give investors a choice between earning almost nothing on their money–as has been the case with most cash instruments over the past several years–and something, anything, they’re usually going to choose something. In fact, I’ve argued that a lack of good alternatives has been the major driver of stock returns over the past several years; even though equity valuations haven’t been compelling, investors naturally want the opportunity to earn a decent return on their money.

An environment in which traditional cash vehicles have yields of less than 1%–and well below the inflation rate–is bound to encourage yield-chasing. While investors want to wring more from their cash, here are some of the key pitfalls to avoid.

Mistake 1: Accepting a minimal yield pickup while taking a lot more risk.

The net effect of declining yields is that the yield differential between higher-risk/higher-yielding securities and lower-risk/lower-yielding securities has gotten compressed. Along the way, something unusual has happened: Security types that offer FDIC protection, such as certificates of deposit, bank-offered money market accounts, checking and savings accounts, and online savings accounts, are actually out-yielding security types without those guarantees. (Credit union savings accounts don’t offer FDIC protection, but they are backed by the National Credit Union Insurance Fund, which is backed by the full faith and credit of the U.S. government. For that reason, credit union accounts are usually deemed on par with FDIC-insured accounts from a safety standpoint.) In essence, you’re currently getting paid more to take less risk.

On the flip side, money market mutual funds, which are not covered by FDIC insurance, are generally yielding less than their FDIC-insured counterparts right now. Meanwhile, some security types currently offer yields as high as or even a bit higher than FDIC-insured instruments, but their risks are substantially higher, too. I’d put floating-rate demand notes in that category; these are short-term notes offered directly to consumers by large companies. They offer liquidity as well as check-writing privileges in some cases, but they are not FDIC-insured and they are tied to the fortunes of a single company. Duke Energy has been a big purveyor of the notes; the most recent yield figure for a $50,000 deposit was 0.90%. To my mind, that seems like insufficient compensation for the risks, especially when you can readily pick up online savings accounts with yields in that same ballpark. Ditto for short-term bond funds and floating-rate funds; while such investments may be reasonably components of investors’ long-term portfolios, their lack of guarantees makes them a poor cash alternative.

Mistake 2: Not actively managing for a higher yield.

Events of the past five years have illustrated that the spot to earn the best yield on your cash is a moving target. Less than a decade ago, money market mutual funds offered better yields than FDIC-insured products–enough to make them compelling alternatives to CDs and other insured product types, despite money market funds’ lack of guarantees. Today, that’s not the case, and investors who have cash sitting fallow in money market funds are likely paying an opportunity cost. (Of course, there may be legitimate reasons for holding a money market fund alongside your long-term investments–to facilitate opportunistic purchases, for example.)

But stay alert to changes on this front. If and when yields finally go up, money market mutual funds may once again offer better yields than CDs and savings accounts. In contrast with your stock and bond investments, where buying and holding is often the right answer, you may have good reason to be more hands-on with your cash accounts. Be aware, however, that, depending on the cash vehicle, you may need to lock your money up a while to earn the highest yields; otherwise, you could face a penalty for an early withdrawal.

Mistake 3: Holding more than you need to.

Cash is an asset class where you’re lucky to earn 1% today. That’s better than putting it under the mattress (just barely) but it means that if inflation runs higher than 1%, you’re in the hole. Thus, at the risk of stating the obvious, don’t hold more cash than you need to. I usually advise retirees to hold anywhere from six months to two years worth of living expenses in true cash instruments. (This article discusses rightsizing your cash stake in retirement if you’re using the bucket system.) Meanwhile, the usual rule of thumb for cash holdings for people who are still working is three to six months worth of living expenses. That’s fine for younger workers who have more latitude to rein in expenses in case of job loss, but people with higher salaries (whose jobs often take longer to replace) or those who work in the “gig” economy will almost certainly want to hold more. Opportunistic investors aiming to pounce if the market sells off will also want to hold additional cash, above and beyond their bucket 1 or emergency-fund needs.

Mistake 4: Ignoring similarly safe uses of your cash if you don’t need the liquidity.

For investors who are seeking a guaranteed “return” on their money but not liquidity, the best use of their cash may be hiding in plain sight: debt pay-down. Of course, it’s a rare cash investor who’s carrying around high-interest credit card or even a home equity loan. But plenty of cash investors also hold mortgages; even if their mortgage interest rates are ultra-low, they’re still higher than what they’re getting paid on their cash holdings, and the “return” they earn by retiring debt is also guaranteed. Of course, prepaying a mortgage won’t make sense in every instance–if you truly need additional liquidity, for example, steering the money into a true cash instrument will be a better use of your funds. Ditto if you’re early in the life of your loan and your mortgage interest deduction is having a meaningful impact on your tax bill.

Mistake 5: Assuming you’re better off in cash than bonds in every instance. 

Many core-type bond funds are yielding anywhere from 1.5% to 3% today, whereas I just pointed out that you can pick up an FDIC-insured savings account with a yield of about 1%. So why would you opt for the bond fund for any part of your portfolio, knowing that it courts interest-rate and possibly credit risk, when you could hold cash instead? The key reason is that if your holding period is sufficiently long–say, at least five years–and you don’t need ready liquidity, a core bond bond fund is likely to out-earn cash, albeit with more bumps along the way. While the bond fund can lose value when interest rates go up, over time it should be able to make up that ground by investing in new, higher-yielding bonds when they become available. And when bond yields go lower bond investors actually benefit, whereas the poor cash investor has to settle for ever-lower yields. That has been the case so far in 2016, for example, though that pattern may not repeat itself any time soon.