Thinking in Real Terms

sabrina_k_gartler-_aams.pngSince the onset of the financial crisis in late 2007, the Federal Reserve has used interest-rate cuts and other policy tools in an effort to fuel economic growth. Economists can debate the effectiveness of these policies, but everyone can agree that today's low interest rates are a two-sided coin.


Consumers, businesses, and government all benefit from low borrowing costs. But on the other side, savers and investors earn almost nothing on their cash balances. This has been the case since 2008, when the Fed cut short-term interest rates to near zero.


Let's Get "Real"


Worse yet, investors are actually losing wealth in real terms. Inflation has the effect of reducing "real" income by reducing the amount of goods or services you can purchase with that income. The inflation-adjusted yields on short-term Treasury securities (like those commonly held in money market/cash funds) have been negative in most months since October 2010. Earning negative real yields on short-term bonds is not unprecedented. Negative real yields have occurred during periods of high interest rates (early 1980s) and during periods of low interest rates (2010–11).


Regardless of the scenario, negative real yields cause investors to lose purchasing power.


Cash is King?


You may also note that some negative real yields have occurred during recessionary periods. These may be times when investors are most tempted to flee the stock market for the perceived safety of cash.


This is the case for many individual investors and professional money managers today. They are reportedly shifting their portfolios to money market funds and other cash instruments with the intent to return to stocks and bonds when the economy shows signs of improvement.1

 

The problem with this strategy is that no one can consistently time markets, and the signs are never clear. So while investors sit in cash, their purchasing power quietly erodes.


Sabina K. Gartler, AAMSInvestors may have good reasons to hold cash—for example, to keep a portion of their assets liquid for an up-coming purchase (buying a new car or home improvements). But they should understand that holding cash has a price in real terms.


No asset is completely "risk-free". Investors must understand the trade-offs between different kinds of risk – say stock market risk vs. inflation risk – and judge which risk is most acceptable for them.

 

Endnote:
1. Jonnelle Marte, "The New Cash Hoarders: Smart or Not-So-Smart?" SmartMoney, June 29, 2011.

Past performance is no guarantee of future results.