One thing to keep in mind if considering going to cash: For some retirees who face RMDs, having a large cash allocation can hurt.
Photo: Rob DobiBig-name investors from Warren Buffett to Leon Cooperman said they went to cash as the fastest bear market in history crushed financial markets in the first quarter. Data from the first quarter suggests many individual investors went to cash as well.
Flows into money-market accounts have topped $1.2 trillion since the start of the drawdown, according to data from EFPR Global.can we link? Money-market flows typically represent cash positions from institutions, businesses and individual investors—basically, anyone who raised cash during the selloff as they pulled back from stocks or bonds, or both.
But while it might feel safer going to cash when markets are volatile, cash positions don’t work like they used to. If you went to cash during the 1987 stock-market crash, you were still making 4.75% to 5.5% interest. If you had gone to cash in the dot-com crash you were making around the same—3.5% to 5.8% interest. Now, high-interest-rate savings accounts offer approximately 1.3% interest.
Of course, fleeing to cash also carries the risk of missing out on a rebound in stocks—which is exactly what happened in April and May, as stocks returned to bull-market levels.
Here is what to keep in mind if you are considering “surrendering”—moving to cash—when markets are volatile.
Making the decision
Investors go to cash for a variety of reasons. Mr. Buffett is likely planning to use his cash to take stakes in newly cheap companies. Most people likely don’t have that option. Individuals typically go to cash when they are uncertain about keeping their jobs, need immediate retirement income or have suddenly discovered their portfolios no longer match their risk tolerance.
Whatever the reason, the decision is likely to lead to an immediate and lasting impact on net wealth, in terms of capital losses, taxes owed and a crimp on growth.
Unexpected consequences
When investors liquidate positions during market downturns, they end up with cash, but typically less than they could have had if they sold at a much later date—assuming markets, and the investments, recover and even rise.
Many investors who sell also make the mistake of assuming that just because they sold during a downturn it will count as a loss. But it’s the initial purchase price that matters, and how you sold. Selling can help with taxes if you work with a financial adviser to tax-loss harvest, but in times of panic people can sell before doing that. You typically end up owing taxes whenever you sell shares for more than they cost when you purchased them. So, if you sell lots of stocks in your portfolio to raise cash, and don’t have actual losses to offset capital gains, be prepared to give some of that cash right back in the form of more taxes owed.
Another consideration is, after age 72, some retirees have to withdraw a certain amount from their retirement accounts each year in what is called a required minimum distribution. RMDs, which are taxable income, are suspended for 2020 but will resume next year. Coupled with unexpected capital gains from going to cash, this could create a real tax headache.
“The RMD is really going to kill you if you’re heavily in cash,” says Richard Marston, a personal-finance author and finance professor at the University of Pennsylvania’s Wharton School. The more cash there is, the bigger the drag on a portfolio’s growth in years that stocks do well, and the RMDs themselves practically guarantee there will be less available capital to work with in years to come. “Even if you’re only spending a reasonable amount from those withdrawals, the cash is not working for you and you have to keep withdrawing and paying taxes on it each year,” says Prof. Marston.
Interest and inflation
Most people aren’t going to be able to fund their retirement on 1.3% interest unless they have a great deal of cash. Meanwhile, most people have nowhere near that much cash, nor the prospects of getting it. Based on the likelihood of deteriorating market conditions, data from the World Economic Forum suggests that millennials would have to save a whopping 40% of their income to retire by age 65. For those with a nest egg already, most aren’t going to be able to sustain their current levels of spending when they retire unless they keep sizable chunks of their portfolios invested.
Low interest rates on savings combined with consumer-price inflation erode wealth. While inflation in the U.S. remains low on a historical basis, it isn’t zero. Grocery prices have increased during the pandemic. Health care as a percentage of individual spending is also at all-time highs and climbing, according to data from the Kaiser Family Foundation. Add housing, and these three indicators make up a significant portion of individual expenses and are unlikely to fall soon. Inflation expectations suggest investors could see their portfolios’ buying power drop by 1% to 2% this year and next. Without a corresponding rise in interest rates, even low inflation eats up the 1.3% interest offered in a high-interest savings account.
Psychological barriers
Behavioral investing data shows that the longer you are in cash, the longer you are likely to stay in cash.
Investors tend to get comfortable knowing that they have a nest egg that doesn’t fluctuate all that much even if it isn’t working for them. Or, they try to time their re-entry into the market.
“Investors either explicitly or implicitly make a lot of decisions by going to cash,” says Stuart Katz, CEO and chief investment officer of wealth-management firm Robertson Stephens. “They think they’ll be able to get back in when the conditions are right, but the conditions are only right after they’ve missed the rally,” he says. Indeed, this has already happened at least in part as stocks have rebounded, although they have been more volatile than in prior years.
Deciding to re-enter
For those who want to get back into the market but aren’t sure how to do it, dollar-cost averaging may be an option, as it allows you to gradually re-enter the market through small but steady reinvestment of cash positions.
Prof. Marston suggests this can help people feel like they are still in control. “It’s a good way to reassess risk,” he says. “But there are drawbacks. The longer you take to get back in, the more you miss out on.”
Amy Arnott, portfolio strategist at fund-tracker Morningstar, agrees. “The data shows that it is actually better if you put a lump sum in at once, in terms of the overall return. That said, investors will have to prepare for more volatility,” she says. While dollar-cost averaging can smooth out portfolio volatility, the trade-off is total return on investment.
Investors may also wish to allocate a bigger portion to cash proxies such as ultrashort-bond funds so that their money is earning more than 1.3%. These funds tend to have one- to three-year maturities and can help provide income in low-yield environments, but Ms. Arnott suggests they should be part of a broader effort to get back into the market if investors want to be on track to meet their long-term financial needs.
Ms. McCann is a writer in New York. She can be reached at reports@wsj.com.
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