The Most Overlooked Threat to Your Buying Power

Decades ago, one of the first things I did when I started looking after our aging parents’ money was move a substantial sum from their checking account to an interest-bearing account. When I asked why they had so much sitting in their checking account, they answered, “You never know. We may want to buy a new car.”

For a long time, the conventional wisdom was to keep 20-35% of a retirement portfolio in cash. Today holding that much cash in the bank or your brokerage account is like a leaky faucet. It leaves your purchasing power going drip, drip, drip. And a bundle hidden under a mattress? Don’t even think about it!

Banks and brokerage firms currently pay somewhere in the neighborhood of 0.01% interest on cash accounts. Sure, some banks offer a really good deal. Deposit $100,000 and they will pay you $500 or thereabouts in interest. Plus, CDs and Treasuries are not particularly helpful alternatives. Right now the best rate for a 1-year CD is about 1.15%; the 1-year Treasury yield is hovering around 0.22%.

In other words, seniors and savers are penalized for holding cash. Most people living on fixed incomes need to update where and how they hold their cash before that leaky faucet turns into an all-out flood.

From Cash to Cash-Like

Holding 30% of your portfolio in safe, liquid, cash-like investments is still the prudent way to go. Retirement investors should risk as little in the market as is necessary to hit their targets.

Here’s how it’s done. Instead of holding the 30% in your brokerage account, hold 30% in safe, liquid, short-term cash instruments that pay higher yields. While they might not yield close to the 6% you’d like, there are still plenty of safe options that yield substantially more than bank or brokerage cash accounts. I’m not talking about unicorns here; solid cash-like investments do exist.

The Risk Trifecta

There are risks, of course, to keep in mind on your hunt. The most important are: default; duration; and beta (market correlation). Let’s look at them independently.

Default risk is the risk of lending money to a borrower unable to pay it all back. To earn a higher yield, you have to take on some default risk. But there are two key ways you can keep this risk to a minimum:

• by buying into a highly diversified, low-cost fund so that no single default would have a major impact on your nest egg; and
• by looking into a fund’s holdings—both the industries they’re involved in and the credit rating (quality) of the debt they hold.

Let’s move on to duration, the sensitivity of a fund’s share price in relation to interest rate changes. A duration of 1 means that for a one percentage point change in interest rates, the fund’s share price is expected to rise or fall by 1% in tandem.

A fund holding 10-year Treasuries with an annual rate of 2.19% and paying coupons quarterly would have a duration of 9.01, meaning that a one percentage point increase in interest rates would cause your share price to drop 9.01%, wiping out several years in interest gains. You would have to either sell the asset at a loss or hold it until maturity while earning below market interest rates. With interest rates as low as they are, you want the lowest possible duration you can find… much less than 1.

Beta indicates the share price of an investment in relation to the market, commonly represented by the S&P 500 Index. Beta shows the relationship between the investment and the “market” over a certain number of years. A beta of 1 means if the market moves up or down by 1%, the share price of the asset will do the same.

The lower the beta, the better. You do not want this portion of our portfolio moving in relation to the market. A beta of 0.001 is very close to zero and means that the investment moves almost independently from the market, or that it has almost no systemic risk.

The ideal investment for your cash-like holdings has minimum default risk and the lowest possible duration and beta; you want it to be independent of the market and interest rate fluctuations.