The risk of cash in a low-interest environment

In the current economic climate, many investors view cash as a safe harbour. Yet as interest rates approach a peak, the hidden risks of relying too heavily on cash have come into sharper focus.

Cash is often touted as the safest investment, particularly in times of economic uncertainty. The logic is simple: cash doesn’t fluctuate in value like stocks or bonds, and it provides liquidity that can be deployed quickly when opportunities arise.

However, cash may not be the risk-free investment it appears to be or once was, and investors would be wise to consider a more diversified approach to managing portfolio risk.

Holding cash comes with significant downsides, especially in a low-interest-rate environment. As interest rates decline, the returns on cash equivalents – such as money market funds, Treasury bills, and certificates of deposit (CDs) – also drop. This can erode purchasing power over time, particularly when inflation is factored in.

The current economic outlook suggests that the central banks such as the Federal Reserve in the US may cut interest rates in the near future, which would further reduce the yield on cash holdings. While the Reserve Bank of Australia may be further away from a rate cut, it is most likely that the next move will be down. Investors who are overly reliant on cash could find themselves facing reinvestment risk—the possibility of being unable to reinvest at the same or higher returns, thereby reducing overall income. This risk is particularly pronounced in a falling interest rate environment, where the returns on cash equivalents will likely follow the downward trajectory of the Fed funds rate.

Another often overlooked risk is the opportunity cost of holding large cash reserves.

While cash provides liquidity and safety, it also means missing out on potential gains from other asset classes. Bonds, for example, can offer attractive yields, particularly in the current high-interest environment. As interest rates begin to fall, the prices of bonds typically rise, providing capital appreciation in addition to yield. This dual benefit is something that cash simply cannot offer.

Investors who remain too heavily weighted in cash risk missing out on these opportunities. As inflation continues to erode the real value of cash, the purchasing power of these holdings diminishes over time. In contrast, a well-diversified portfolio that includes bonds and other income-generating assets can help mitigate these risks while providing the potential for growth.

Given the risks associated with a cash-heavy investment strategy, diversification becomes crucial. While it’s important to maintain some level of liquidity, particularly for short-term needs, investors should also consider allocating a portion of their portfolio to bonds and other income-generating assets. Investment-grade bonds, in particular, offer an attractive combination of yield and capital appreciation potential, especially as interest rates begin to decline.

Bonds with longer durations are particularly appealing in this environment, as they tend to experience greater price appreciation when interest rates fall. This can help offset the lower yields that cash investments will likely generate in a declining interest rate environment. By locking in today’s higher yields, investors can secure a steady stream of income while positioning their portfolios for potential capital gains.

While cash has its place in a well-rounded investment strategy, relying too heavily on it can expose investors to significant risks, particularly in a low-interest-rate environment. The key to managing these risks lies in diversification—balancing the safety and liquidity of cash with the yield and growth potential of bonds and other income-generating assets. By doing so, investors can better position themselves to weather economic uncertainty while still pursuing long-term growth.

By Balaji Venkataraman, client portfolio manager and Joyce Huang, senior client portfolio manager.