Falling interest rates have advisors confronting a seemingly counterproductive phenomenon: Even as the returns that can be made on cash holdings dwindle, investors keep plowing into money markets rather than stocks and bonds.
The research firm Crane Data reported that cash investments in money market funds exceeded $7.7 trillion for the first time. That record was hit even as interest rates on money markets, which typically invest in short-term government and corporate debt, have fallen from offering an average yield of more than 5% as recently as last year to 3.7% now, according to Crane.
Investors piled into money markets after the Federal Reserve in 2022 began hiking its key interest rate in a bid to tame inflation. Like many financial products, money markets’ rates are tied to that federal funds rate.
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The Federal Reserve last week approved a cut bringing that rate down to a range of 4% to 4.25%. That’s down more than a full percentage point from the range at its peak.
Are clients caught in a ‘cash trap’?
Well before this recent round of debate over rate reductions, large wealth managers like JPMorgan were telling investors not to let themselves be lulled into a “cash trap.” Savers, the firm warned, should be considering stocks and other investments with track records of generating higher returns, particularly if they wanted to stay ahead of inflation.
Still, even as the Fed and analysts have signaled more rate cuts are likely this year, cash is flowing into money markets unabated.
Peter Crane, the president of Crane Data and the publisher of the Money Fund Intelligence newsletter, said warnings about cash overlook a common tendency in investor behavior. Savers are rarely looking at two distinct types of investment like stocks and money markets and then deciding to put their money into whichever is likely to offer the best yields.
Rather, they’re deciding how much of their portfolio they want to keep in cash and choosing whether that share should be placed in money markets or similar products, most often savings accounts. In other words, “cash competes with cash,” Crane said. Crane predicted the amount of cash in money markets will easily top $8 trillion before the end of the year.
“Money markets are going to continue taking market share from bank deposits, and not stocks, because the yields on bank deposits still suck,” he added.
For advisors, cash isn’t always king
There are signs, though, that advisors are not altogether comfortable with the size of their clients’ cash holdings. In Financial Planning’s September Financial Advisor Confidence Outlook (FACO) poll of just over 200 advisors, a quarter of the respondents said they’d like to decrease their clients’ allotments to cash in the coming months.
Among different types of investments, cash had the highest percentage of advisors saying they wanted to lower allotments. (Only 12% said their clients should have less money in stocks.) On the flip side, only 21% of the respondents said they think their clients should move more into cash, while roughly half said there should be no change.
Sometimes having a compelling augment for having clients move their investments out of cash, and getting them to actually do it, are entirely different things. Alex Caswell, the founder of WealthScript Advisors in San Francisco, said clients should generally have enough cash on hand to cover their expenses for three to six months, in case of an emergency. They should also set aside money to pay for planned big expenses, like vacations or remodeling projects.
Beyond that, clients should almost always be dividing their portfolios among stocks, bonds and possibly alternative assets like gold. The likely returns from noncash investments are simply too great, he said.
Giving hesitant investors a nudge into stocks, bonds
But convincing clients of that basic investing truth isn’t always easy. Plenty of investors will look at the current stock market and conclude that most companies’ shares are too expensive.
With the S&P 500 index hitting record highs, many inventors are waiting for prices to start coming down before plunging in. And even if values do fall, some will try to ascertain if they’ve hit rock bottom before they start buying stocks.
“These are pretty bad investment behaviors that I, as an advisor, try to get clients to avoid,” Caswell said.
Caswell said he can make a case that the market is both overpriced and that its current bull run still has lots of room to run. For clients who are hesitant about investing, Caswell recommends considering a dollar-cost-averaging strategy. This has them commit to moving a certain amount of cash into stocks, bonds or other investments regardless of current market conditions.
Caswell said he’ll sometimes stagger these allocations by setting up a CD ladder. He’ll have clients buy bank certificates of deposit — a common savings instrument — with maturity dates ranging anywhere from three months to several years out. As the CDs hit those varying maturity dates over time, clients can take the money out and shift it over to other investments.
Caswell acknowledged there are plenty of studies suggesting dollar cost averaging can lead to diminished returns over the long run. But it’s better than just leaving everything in cash, whose value is constantly being whittled away by inflation.
And advisors always have to keep investor psychology in mind. Investors who are already hesitant to invest are going to be particularly sensitive to the pain caused by losses.
“The feeling of potential regret on the part of the client should be a really strong consideration,” Caswell said. “It could lead to worse financial decisions down the road. A painful experience can carry for decades.”
The case for bonds when rates are falling
Bonds also garner attention when rates are falling. Many wealth managers say quality government and corporate debt offer investors an easy way to “lock in” higher yields because they offer a consistent yield until their maturity date — whether that is months or years away.
Another advantage to buying bonds when rates are falling comes from the investing axiom that bond prices move inversely to yields. Kevin Brady, a senior vice president at Wealthspire Advisors in New York, said he and his colleagues are advising clients to move excess cash they aren’t expecting to need anytime soon into bonds with maturity dates four to five years out.
Those allocations will not only lock in higher yields, Brady said, but also “position their portfolio to benefit from price appreciation of those bonds should rates, in fact, drop.
“An intermediate duration of about five years tends to be a nice middle ground between not extending duration too far should rates go the other way, while getting appreciation potential,” he added.
Nathan Sebasta, the owner of Access Wealth Strategies in Artesia, New Mexico, said bonds can provide stability to portfolios by providing a steady source of income. Cash, by contrast, is likely to lose purchasing power over time owing to inflation.
“Staying all in cash for too long can actually increase long-term risk,” Sebasta said.
Crane, though, thinks such advice will make nary a dent on the money flowing into money markets. He noted that the rates paid on bonds and bank deposits tend to be much more directly tied to Fed policy.
Money market yields will eventually come down, too. But they tend to be on more of a lag, Crane said, meaning they will still present an attractive alternative.
“Cash will keep coming into money market funds contrary to Wall Street expectations,” he said.
