The recent rise in “risk-free” short-term interest rates has many people reconsidering the risk vs. reward dynamic relative to the stock market. While the increase in yields is welcomed relief compared to the historically low interest rates of the past 15 years, it is important for investors not to lose sight of the primary purpose of investing, which is to grow assets at a sufficient rate to stay ahead of inflation and provide a consistent stream of income for one’s life. While cash/cash equivalent investments serve an important short-term role in portfolios, do not lose sight of the longer term. Below are some concepts to help you think through the short-term desire for stability and the long-term desire for portfolio growth.
Nominal vs. Real Rates
One of the most important aspects of understanding the risk of the “risk-free” rate is the difference between nominal rates and real rates. The nominal rate of return is the rate of return before inflation, while the real rate of return is after inflation is considered. For example, if a stock investment’s nominal rate of return is 5% and inflation is 2%, then the real rate of return is 3%. Currently, the risk-free rate of return on cash/cash equivalent investments is approximately 4-5%, and with the latest inflation data running at approximately 6%, the real rate of return on these assets is still negative. So, even with a higher “risk-free” nominal rate, don’t lose sight of inflation and your real rate of return.
Risk-Free Assets vs. Risk Assets Longer Term
While higher risk-free rates on cash/cash equivalents can be appealing in the short term, the longer- term return expectations on these assets compared to risk assets such as stocks, real estate, etc., is not. In fact, since 1928, the rate of return on stocks, bonds, and cash averaged approximately 9.6%, 4.6%, and 3.3%, respectively. With inflation factored in, the real return for these asset classes dropped to 6.5%, 1.5%, and 0.2%, respectively. Recommendation: Structure your portfolio to provide for stability and liquidity in the short run without abandoning risk assets and the long-term growth they can offer.
Avoid the Binary Choice (All Cash/Bonds vs. All Stocks)
With risk-free rates at their highest level in over a decade, the calls to abandon risk assets for safety and security are at a fever pitch. While there is always a place for risk-free assets within a portfolio, investors should consider striking a balance between risk/risk-free assets. Recommendation: Try to avoid the binary choice of all-in or all-out of risk-free assets. For pre-retirees and retirees, a heavier bias towards risk-free assets may be warranted. If you have a longer time horizon, play the long game with a healthy mix of risk assets such as stocks, real estate, etc., as they will help you better defend against, and stay ahead of, inflation.
If you are concerned about how to balance your portfolio in a way that pays respect to your short-term desire for stability without sacrificing your longer-term goal of growth, we would love to start a conversation!
All situations are unique to everyone; be sure to consult with a Certified Financial Planning Professional to make a strategy that best fits your needs.
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