Trade-offs of holding cash
Investment decisions have trade-offs. Those who invest in cash have a primary goal of preserving principal. Cash or cash equivalents are readily available short-term financial instruments that are highly liquid, have minimal or negligible market risk, and have a maturity within 90 days.2 When investors choose to invest in cash, they will generally maintain their principal while earning interest income with low return volatility. The trade-offs, however, can include reinvestment risk, lower long-term returns, low to negative real returns because of the effects of inflation, and reduced portfolio diversification when needed most.
Normally, bonds with longer maturities require higher yields to compensate investors for additional risks. Occasionally, there are periods when this relationship doesn't hold, as we see today, and investors can earn more income in cash and short-dated bonds than in longer-dated bonds. We do not believe that trend is sustainable.
As of June 30, 2024, 1-month U.S. Treasury bills were yielding 5.5%, while 10-year U.S. Treasury bonds were yielding 4.4%.3 This can be an attractive proposition for many investors, but remember that different maturity profiles can result in differing long-term return expectations. In the case of the 10-year bond, investors would be receiving a yield of 4.4% per year for the next 10 years if that bond were held to maturity. In the case of the 1-month Treasury bill, investors would receive an annualized rate of return of 5.5% for the next one month. When the original principal is received one month later, at maturity, the market rate for reinvestment is unknown, as yields could be higher or lower. Therefore, reinvestment risk may be associated with the one-month investment compared with the 10-year investment over the next decade. The risk is that if yields were to fall, the investor would begin to earn a yield lower than what they could have earned by investing in the 10-year bond. While longer-dated bonds generally have more yield durability, all investors should consider their time horizon when making investment decisions.
Longer-dated bonds typically provide higher income, a key driver of their superior long-term returns compared with cash, as most of a bond investor's total return comes from earned income. During the last 30 years, the average annual return of the broad U.S. bond market has been 4.4%—more than double the return of cash. Furthermore, the Consumer Price Index, a measure of broad-based inflation, averaged 2.5% over the same time. Although cash and bond investors would have seen their balances increase, investors in cash lost purchasing power, or wealth, in real terms, as inflation grew at a higher annualized rate relative to cash.
In this box and whisker chart, using Vanguard's proprietary forecasting model, the Vanguard Capital Markets Model® (VCMM), we show that bonds are expected to continue outperforming cash over the long term. Even though our model forecasts a positive inflation-adjusted return for cash over the next 30 years, its limited ability to keep up with inflation considerably erodes purchasing power.
Projected 30-year returns for equities, bonds, and cash
IMPORTANT: The projections or other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from the VCMM are derived from 10,000 simulations for each modeled asset class. Simulations are as of March 31, 2024. Results from the model may vary with each use and over time. For more information, please see the Notes section below.
Notes: These return assumptions depend on current market conditions and, as such, may change over time. We make our updated forecasts available quarterly.
Source: Vanguard Investment Strategy Group.
Portfolio efficiency trade-offs can also occur when asset classes are added or removed from an investor's allocation. An allocation to cash, for example, safeguards that portion of the portfolio from market risk, but it may not pair as well with other asset classes—especially equities. While cash helps with preserving principal, it lacks duration. Although this can be beneficial when interest rates are rising, the buffering effects of cash fade when interest rates are falling. Cash has a high, positive correlation to changes in the federal funds rate. When the economy begins to slow and equity markets sell off, there is generally a reduction in the federal funds rate to help spur economic growth. As this rate falls, cash yields fall, but bond prices rise, helping to offset unrealized equity losses. Since 1994, in periods when U.S. equities had a negative 12-month return, the median annual return of bonds was about 7.6%, versus 1.4% for cash. As shown in this bar chart, when considered in the context of a balanced total portfolio and despite their own risks, bonds have historically done a better job buffering against equity losses in down markets.
Bonds tend to provide better downside protection against equity losses
Notes: U.S. equities represented by Dow Jones U.S. Total Stock Market Index (formerly known as the Dow Jones Wilshire 5000 Index) through April 22, 2005; MSCI US Broad Market Index through June 2, 2013; and CRSP US Total Market Index thereafter. U.S. bonds represented by Bloomberg U.S. Aggregate Bond Index through December 31, 2009; Bloomberg U.S. Aggregate Float Adjusted Index thereafter. U.S. cash represented by Money Market Funds Average through November 30, 2020; U.S. Government Money Market Funds Average thereafter. Derived from data provided by Lipper, a Thomson Reuters Company.
Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
Bonds tend to outperform cash once the Fed stops raising rates
It's understandable that high-yielding money market funds might tempt some investors to hold more cash and less in bonds until the Fed begins cutting interest rates. However, bonds historically have outperformed cash over short, intermediate, and longer-term time horizons following the peak of Fed tightening cycles. The line chart shows the cumulative growth of cash and bonds following a period of aggressive Fed monetary policy during 1999 and 2000, in response to the dot-com bubble. From the date of the Fed's final rate hike on May 16, 2000, bonds returned a cumulative 87.9%, versus 34.4% for cash over a 10-year period.
Cumulative growth of bonds and cash over 10 years following the peak of a Fed rate-tightening cycle
Notes: Federal funds target rate represents the upper limit of the target range established by the Federal Open Market Committee. Cash returns are represented by Vanguard Cash Reserves Federal Money Market Fund Admiral™ Shares; bond returns represented by the Vanguard Total Bond Market Index Fund Institutional Shares.
Sources: FactSet; Vanguard calculations, using daily fund returns from May 16, 2000, through May 16, 2010.
We expand the analysis in the table that follows to include three other rate-tightening cycles that occurred within the past 30 years. We show the annualized total returns for cash and bonds for the 1-, 3-, 5-, and 10-year periods following the Fed's final rate hike during each respective cycle. Except for the 5-year period that ended on December 20, 2023, (which includes the recent 2022–2023 rate increases), bonds have outperformed cash by a comfortable margin. While past performance doesn't guarantee future results—and this cycle could be different—we believe bonds are superior to cash for meeting most investors' long-term goals.
Bonds have mostly outperformed cash following the end of multiple Fed tightening cycles since 1995
Annualized total return from date of last rate hike |
||||||||
|---|---|---|---|---|---|---|---|---|
| Date of the last Fed rate hike | 1-year Cash | Bonds | 3-year Cash | Bonds | 5-year Cash | Bonds | 10-year Cash | Bonds |
| 2/1/1995 | 6.0% | 16.7% | 5.7% | 10.0% | 5.6% | 7.2% | 4.2% | 7.3% |
| 5/16/2000 | 6.4% | 13.9% | 3.6% | 10.5% | 2.8% | 7.5% | 3.0% | 6.5% |
| 6/29/2006 | 5.4% | 6.4% | 3.8% | 6.8% | 2.4% | 6.8% | 1.2% | 5.2% |
| 12/20/2018 | 2.3% | 8.9% | 1.0% | 5.0% | 1.9% | 1.1% | — | — |
Notes: Cash returns are represented by Vanguard Cash Reserves Federal Money Market Fund Admiral Shares; bond returns represented by Vanguard Total Bond Market Index Fund Investor Shares for periods beginning February 1, 1995, and Vanguard Total Bond Market Index Fund Institutional Shares for all other periods.
Past performance is no guarantee of future results.
Sources: Federal Reserve; Vanguard calculations, using daily fund returns.
Making sense of cash investments
When will the Fed start cutting interest rates? That's hard to predict, and the decision is not something investors can control. Plan sponsors focused on the financial well-being of their participants should approach the "cash versus bonds" debate objectively.
Cash can be a tool for managing liquidity risk, such as meeting day-to-day needs and saving for emergencies. A strategic allocation to cash may also make sense for some investors with short-term goals and low risk tolerance. However, even in today's high-yielding environment, cash investments should not be viewed as a substitute for stocks or bonds. Additionally, overweighting cash and trying to time reentry into bonds can come at the cost of long-term underperformance and the risk of falling short of one's financial goals.
| Total returns | 1-year | 5-year | 10-year | Expense ratio | Periods ended September 30, 2024 7-day SEC yield |
|---|---|---|---|---|---|
| Vanguard Cash Reserves Federal Money Market Fund Admiral Shares | 5.42% | 2.33% | 1.72% | 0.10% | 4.88% |
| Vanguard Total Bond Market Index Fund Institutional Shares | 11.42% | 0.32% | 1.83% | 0.035% | — |
