One of the most common fundamental questions for beginning investors is whether to invest or save the hard-earned spare cash that they have on-hand. In the following blog post below, we will share our views and a few considerations that may help inform your decision-making on how to allocate your financial resources.
In the long run (10+ years), investing can bring much higher returns for wealth accumulation and keeping extra cash in savings accounts would NOT be a wise decision because of the missed returns and erosion of purchasing power due to inflation. However, in the short-term, most Wall Street analysts expect the market to trade sideways or to return only 4-5% annually by the end of 2023 given that the Federal Reserve is expected to maintain a high interest rate through 2023 and gradually taper down rates through 2024. As a result, according to Bank of America’s recent note to investors, money market funds hit a record high of $4.8T. The main reason for why so many investors are parking their cash in money market funds is because of the attractive interest rates which is effectively guarantee a 4-5% return with very low risk. If you look at the near-term opportunity cost of storing your money in money market funds vs. investing in equities, the risk reward payout does not favor investing in stocks as long as the Fed keeps raising the rates. (If you can receive 4-5% guaranteed and risk-free, why would you invest in stocks when its forecasted to return the same in the near-term, but you could also lose money? Studies have shown that for investors holding stocks less than 1 year, there is anywhere from a 30-50% chance of losing money!) This is the reason why the smart money often recommend not fighting the Fed.
Below, we’ve summarized our initial perspective for the average investor to consider when thinking about how to allocate their excess cash:
20%+ Guaranteed Returns
If you currently have outstanding debt (e.g., credit cards, auto loans), you should pay down your debt immediately especially if it has a high interest variable rate. Similar to the concept of reinvesting dividends to maximize your return, keeping a balance on high interest variable debt could have a negative compounding effect on your personal finances, especially if the Fed continues to raise interest rates.
- Therefore, pay off the balance in full if you can because this is a guaranteed return of 20%-25% depending on your credit card’s interest rate. You are unlikely to find any investment in the public or private markets with a comparable return.
- Do not consider using margin or leverage to trade during times of high market volatility as this is extremely risky and there’s a much higher probability that you could lose significantly more than you could earn. Elon Musk also recently cautioned against this approach.
4%+ Risk-Free Opportunity Cost
If you do not have 1-2 years of cash for your emergency fund or 2-4 years for retirees, then you may want to build your cash reserves in a high yield savings account or CD account.
- Generally, financial advisors will suggest 6 months of cash for your emergency fund during a stable economy, however, with a potential recession, persistent inflation and increasing layoffs, 1-2 years of savings will help provide “peace of mind” to cover your expenses in case you lose your job
- According to Depositaccounts.com, several online high-yield savings accounts are offering rates higher than 4% with Popular Direct offering rates as high as 4.40% APY. These rates are attractive because even though it is still below the rate of inflation, the interest is meaningful because we expect inflation to trend downwards over the next two years. For CD rates, Capital One is now offering 5% APY for an 11-month CD!
Time to Enter the Market
Once you’ve paid down your bad debt and have built sufficient cash reserves for your emergency fund, then the key investing question most are considering is WHEN is the right time to enter the market? Most professionals have cited that when the Fed starts reducing the interest rate, that is when investors should start to dip back into the market. The concern is that what if once the Fed starts to lower the rates and we see a subsequent spike in inflation and the market drops again? This is a potential scenario that professional investors have suggested (e.g., Michael Burry from the Big Short, Charlie Munger, Ray Dalio). The reality is that there is still a lot of uncertainty with the market and no one can time the market perfectly, not even professionals. The approach my wife and I will take is to strategically buy the S&P 500 via dollar-cost averaging based on the Fed’s approach to rates. We will not begin re-entering the market until the Fed stops rate hikes and begins to decrease rates even if that means that 1) we could miss out on short-term bear rallies and 2) we could lose money if inflation spikes again and the fed will need to increase rates again. During times of economic uncertainty, we would rather be cautious and besides, with 3-month treasuries paying 5% and potentially higher if the Fed continues to hike, we are getting paid to wait.
Finally, our current economic environment is extremely unique and while most financial professionals like to draw upon lessons from historical decades, it’s important to note that this can be dangerous when trying to extrapolate which assets might outperform during times of recession and high inflation because:
1. We’ve never had the level of US debt that we have now AND
2. The Fed’s current approach of rapidly hiking rates and QT seems to have had limited impact on taming inflation given the strength of the economy AND
3. Historical performance does not imply future performance
According to the historical asset class returns data from NYU’s Professor Aswath Damodaran, performance of asset classes during times of recession and inflation have been cyclical and trying to pick specific asset classes to invest at the right time over the next 2 years could be a risky move given the uncertainty with our environment. There seems to be a lack of correlation across years. For instance, if we were to look at the recent decades of 1973-1975, 1980-1982 and 1990-1991 recessionary periods, these were the years with high inflation rates AND high fed funds rates. For 1973 and 1974, gold was the clear winner but in 1975, the S&P 500 rebounded and outperformed all assets . During 1980-1982, the S&P 500 was the winner in 1980, the 3-month T Bill in 1981 and the US Treasury Bond in 1982. In 1990, the winner was the 3-month T-bill, but then 1991, the S&P 500 was the clear winner again.
As a long-term investor, we will continue to maintain having a diversified portfolio approach with a focus on predictable cash flow (e.g., dividends, bond distributions) in the near-term and be cautious with risk especially when there is uncertainty with the Fed’s approach to rates.
Hopefully, this provides some additional context to inform your own decision-making. Please note that the above is NOT financial advice, but reflect our thoughts on how we are managing our wealth.
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