Cash Trap

Trying to avoid having a “short-term memory” when it comes to investing isn’t always easy.  Look at last year (2022) - as uncertainty filled the markets, many investors sought refuge in conservative investments such as CD’s and money market funds.  Major equity indices such as the S&P 500 and the NASDAQ Composite experienced losses of -19.44% and -33.1% respectively, and the aggressive increase in rates shocked bond markets (as rates rise, current bond values drop) which led to a historically poor performance for bond prices in 2022.  Because of this, some investors chose the path of least resistance and grasped for cash-like investments such as CDs and Money Market Funds as a safety net against stocks and bonds.

Over the last decade, the idea of obtaining a fixed rate of 4+% in short-term CDs and close to that in variable interest rate money market funds was a dream which recently became a reality. 

In the current environment - which is unusual - short-term rates are higher than longer-term rates, complicating matters as investors find it difficult to pass on the short term higher rates even though they might not last long. 

So, how long will the high rates last?  Looking back on previous interest rate cycles, when the Federal Reserve starts cutting rates, they’ve averaged a 200 basis point reduction within the first year.  This would bring rates from around 5% closer to 3%.  If you selected a one-year maturity for your CD, you’ll be faced with a potential reduction in your returns at maturity if you decide to reinvest in another CD.

With the above being said, It is always important to tie back your investment goals with the use of particular products…i.e. short term maturity CDs aren’t a great substitute for long term investments.   If the money set aside in money market and short-term investments is there for a specific reason such as paying off a debt, tuition payments, or a real estate purchase - then  money market or other cash-like investments are still appropriate even with a reduction in interest rates.  

It’s natural for investors to want to shy away from stocks, bonds, real estate, etc. when they experience a major downturn, but more often than not, these downturns present opportunities as conditions change. Clearly, this is evident by the recent increase in stock prices year-to-date.  

In short, CD’s (especially when rates are relatively higher) are a nice alternative to parking your funds in cash if there is a short term need.  Be cautious of getting “trapped” in the cycle of using these types of products as an equity and/or bond substitute. 

As always, if you have questions or concerns about your individual situation, please don’t hesitate to contact us.