The Risks of Carrying Cash as Interest Rates Decline

The recent increase in assets within money market funds, which have reached unprecedented levels, has raised concerns about reinvestment risk as the Federal Reserve begins a rate-cutting cycle.

In recent years, holding cash has ensured stable returns, but investors may now encounter lower yields as interest rates decline, making it difficult to reinvest at comparable levels, according to a report from Wells Fargo strategists.

Reinvestment risk poses a significant challenge. While investors are currently earning nearly 5% on their cash holdings in money market funds, finding low-risk investment alternatives with similar yields may become increasingly difficult as rates continue to fall.

Looking at the longer term, another risk emerges—cash drag on portfolio performance. Historically, higher-risk assets like equities have substantially outperformed cash investments. For instance, an investment of $1 million in small-cap equities in 1926 would have grown to an astonishing $62 billion, whereas the same amount in Treasury bills would have only reached $24 million over the same timeframe.

The report emphasizes, “On a risk-adjusted basis measured by the Sharpe ratios, our long-term capital market assumptions study shows that U.S. equities have consistently outperformed cash returns.”

It further warns, “The power of compounding returns generally favors riskier assets like equities, leaving cash in a less advantageous position for long-term investors. Therefore, we advise against relying on cash as a long-term investment strategy or making it a significant allocation of your portfolio.”

For those reconsidering cash-heavy portfolios, Wells Fargo recommends diversifying across various asset classes to achieve a balance between risk and return.

Though it may be tempting to make a drastic shift into higher-risk assets, the report advocates for a more measured approach, such as dollar-cost averaging into a diversified portfolio. This strategy can help investors seek growth potential while managing risks associated with declining interest rates, all while working toward long-term financial objectives.

The stock market has experienced notable volatility in recent months, with the S&P 500 Index dropping from around 5670 to 5150 between July and August, then recovering to about 5650 by the end of August, followed by a decline to approximately 5400 before scaling back to all-time highs.

This volatility has largely stemmed from a tension between fears of a potential recession and hopes for a soft landing, influenced by a slowing economy, changes in monetary policy, and the impending elections. Many are now debating whether an economic or earnings recession is on the horizon.

Nevertheless, Wells Fargo strategists assert that the current outlook indicates a mild slowdown, rather than a severe recession, with expectations of recovery by late 2025.