High-Yield Savings: Safe Investment or A Cash Trap?

True Root Financial is a financial advisor and financial planner based in San Francisco, CA. We serve clients across the globe.

In today’s volatile financial landscape, the allure of high-yield savings accounts, Treasury bills, and money-market funds can seem like a secure choice, but that’s when you fall into the ‘cash trap’.

Key takeaways:

• Investors who are enjoying high-yield savings and similar cash investments should realize that they might be falling into a cash trap that come with unwanted risks
• The risks of a cash trap are missed opportunities for higher gains, your money not keeping up with inflation,  difficulty of finding an entry point back into the market, higher taxes and higher fees
• If you are sitting on cash because you feel uncertain about the future, remember that the future is always uncertain. Overwhelming research shows that it’s best to invest right away in a diversified portfolio rather than to try to time the market
• At True Root Financial, we can help you invest your cash in a way that strikes a balance between safety and growth

What is a cash trap and why is it dangerous? 

Since the Fed started raising interest rates, investors have been putting more money into high-yield savings accounts and similar cash investments. This surge has boosted assets in money-market funds to a record $6.12 trillion as of June 2024. Previously, savings accounts offered returns of less than 1%, but now they’re yielding as much as 5%. Investors who opted for these high-yield accounts and cash-like investments were pleased with these returns. However, if they had invested in stocks and bonds instead, their returns could have been significantly higher. 

What’s concerning is that the appeal of these newfound cash returns can trap investors. This delays them from making more appropriate investments based on factors such as their age, savings goals, and overall financial plans. In the long-term, investors are left with a lower returning portfolio that may not keep up with their spending. 

Assets in Money market funds as of June, 2024

Source: Investment Company Institute

What are the risks of sitting on cash and cash-like investments? 

1. Opportunity Cost:

One of the most significant risks of the cash trap is that you are left with lower returns and thus are not able to spend on things like buying a house or hitting the life milestones you wanted. While holding cash or cash equivalents, investors may miss out on higher returns offered by stocks, bonds, and other investment vehicles. Since the Fed started raising rates from the end of 2021 to May, 20241 ,the Vanguard Federal Money Market Fund returned 9.1%, whereas the S&P 500 rose 15.1% over the same period when including price changes and dividend payments .

Let’s see how cash has actually performed historically 

The chart below shows the performance of different assets from 2009 to the present. A diversified portfolio is shown in white and Cash appears in purple. In the 14 years from 2009 through 2023, a diversified portfolio has beaten cash 10 times. Additionally, if you had invested in cash from 2009-2023, your return would have been 0.8% annualized. If you had invested in a diversified portfolio instead, your return would have been 8.1% annualized. 

Source: J.P Morgan asset management

2. Dificulty in finding an entry point back into the market:

Many investors who are currently sitting on high yield savings accounts or other cash like investments might think that they will start buying stocks once interest rates go down. But, knowing when  rates will go down is difficult to predict even for Wall Street pros. Just in 2024, the Fed has changed their messaging regarding interest rates multiple times. When we started the year, the Fed was supposed to cut interest rates 6 times this year and now it might just be one time. The more you delay investing in stocks and bonds, the more you forego the possibility of higher returns. Additionally, trying to time the market is extremely difficult, if not impossible and may lead to more mistakes. 

3. Inflation Erosion:

Over time, your cash may not keep up with the way everything around you is getting more expensive. Even if you earn a 5% return, if things around you are getting expensive more rapidly which they are, the actual value of your cash investments may not grow much. Inflation gradually reduces the worth of cash, making it less reliable for long-term investing.

4. Tax Implications:

The return you earn from high yield savings accounts and money market comes to you as interest payments. When you get this interest, you also have to pay income tax on it. This income tax, also known as ordinary income tax, is typically higher than the long-term capital gains tax rate you would pay on any stock sale. This means that once you pay taxes, the return on cash like investments are even lower. 

5. Higher Fees:

Despite the lower returns in money market funds, they still tend to have higher fees compared to stock funds such as ETFs. These fees can eat into the returns, making cash investments less attractive over the long haul.

Do you have cash sitting in your retirement accounts? 

Investors will often leave money in cash-like investments like money markets or stable value funds in their IRAs and 401(k) accounts. Since you will likely keep the money in the retirement account for a long time, it’s best to invest these funds right away in a mix of stocks and bonds based on your age, income, savings and goals. The risks of staying in cash in retirement accounts are the same as we described above. At True Root Financial, we can also help you invest your retirement assets such as 401K and IRA  so that it continues to grow and add to your financial arsenal.

Here are few tips to not fall into the trap 

While the safety of cash investments is appealing it’s crucial to strike a balance between safety and growth. Here are some strategies to avoid the cash trap and maintain a healthy investment portfolio:

• Invest right away: We’ve noticed that the longer you wait to invest the cash and the bigger that pile becomes,  the more difficult it becomes to start investing. So, invest your savings right away. Automate it so that you don’t have to think about it and it’s not an emotional decision every time.
• Diversify Your Investments: Diversification is key to managing risk and ensuring growth. A well-diversified portfolio includes a mix of asset classes such as stocks, bonds and other types of investments. This approach helps mitigate the risks associated with any single investment.
• Consider Bonds: While cash-like investments are safe, bonds offer a balance between risk and return. Long-term investors should consider diversifying into bonds, which can lock in attractive yields before the Fed starts cutting rates.

Here’s the next step for you

Looking for help with investing? Let us help you avoid the trap and guide you toward financial freedom. Book a call below: 

You may also like

Withdrawing from your 401(k)? CARES Act can help

What happens to your tax liability with proper financial planning?

Tech Professionals: Here’s How To Save For Retirement

My 401K is tanking. What should I do?