How much is too much cash in your portfolio?

Stubbornly high interest rates have given renewed luster to cash as an investment. Yet while cash may feel as familiar and safe as memories of your childhood piggy bank or first savings passbook, investors often misunderstand the role it should play in their portfolios, says Matthew Diczok, head of fixed income strategy in the Chief Investment Office for Merrill and Bank of America Private Bank.

"Some perceive cash as a risk-free haven when equities and other markets become too volatile, while others may see it as more or less interchangeable with bonds," he notes. "The fact is cash is a distinct asset class with its own properties, advantages and risks. So, it's important to be as strategic about cash as you are about any other investment."

Cash and cash equivalents such as certificates of deposit (CDs) or money market funds are among the safest and most liquid of investments. Cash is available when you need it and, unlike stocks, there's little risk to principal, especially since most savings and checking accounts, CDs and money market deposit accounts (MMDAs) are FDIC-insured for up to $250,000 per depositor.Footnote ¹

Small wonder, then, that when volatility rises, nervous investors may feel inclined to sell other assets and put the money in cash and cash equivalents. "We saw a lot of that in 2022, when both stocks and bonds underperformed," Diczok recalls. Yet that "flight to safety" contains hidden risks that can undermine portfolio performance and impede your ability to reach your long-term goals.

While cash yields offer some inflation protection — short-term rates often rise with inflation — cash has historically not been able to help you achieve one of the most important long-term investing goals: returning more than inflation. "If you're not generating returns above the inflation rate, you're not increasing your purchasing power over time; you're essentially on an investment treadmill, not really getting anywhere," Diczok says.

Another downside to cash: "reinvestment risk" — the financial cost of having to invest cash flows at potentially lower yields in the future. Short-term interest rates can change dramatically and quickly, and if you haven't "locked in" rates for a longer period of time, you are subject to those market moves. Say you've purchased a one-year CD at 3% interest, and rates drop. When your original CD matures, you'd likely have to accept a lower yield if you wanted to purchase another short-term CD. Diczok also points to the 2008-2009 financial crisis, when nervous investors persistently increased their cash allocations for many years. "Many investors missed out on years of historic market growth, which really hurt their long-term performance." Numerous studies highlight the dramatic impact that missing even a handful of the equity market's best days can have on a portfolio.

Nor is cash a substitute for bonds, which remain an important tool for offsetting the risks of stock volatility in a portfolio. While high-quality bonds and cash offer both stable principal amounts and generally higher yields, longer-date bonds (for example, long-date bonds such as Treasurys with a duration of 10 years or more) offer reliable income with lower reinvestment risk and, generally, higher returns than cash or short-term bonds over longer time periods, Diczok says.

Recent conditions have temporarily muddied that important distinction. Recent rapid interest rate hikes, intended to counter inflation, have driven short-term rates (including those you might get from a money market or other cash vehicle) above the rates for long-term bonds. Yet if inflation drops and the economy enters a recession, that rare situation — known as an "inverted yield curve" — could easily reverse. As interest rates decline, investors who chose cash over, say, a 10-year Treasury bond, may wish they had locked in that steady return, Diczok says.

While the precise percentages depend on one's personal situation and needs, cash should occupy only a small place in most investment portfolios, relative to stocks and bonds, Diczok believes. Yet cash does serve two important strategic purposes:

Money for emergencies: "You need some reserves in case you lose a job, have an accident or face unexpected medical bills," he says. Otherwise, you might have to sell stocks or other assets at inopportune times. Because it must be available without notice, this cash should be in highly liquid forms, such as bank savings or checking accounts, Diczok advises. While the amount will vary depending on your needs, savings to last at least three months is advisable, he says.

Money to be invested: The second pool involves money you plan to invest soon but are awaiting the right time or opportunity. This money should be kept separate from your emergency fund, in accounts that you can tap relatively quickly. The cash investment vehicles you use should be guided by the time you have before you plan to deploy it. Bank accounts or a traditional money market mutual fund will provide immediate daily access to your cash.