A few years ago, when interest rates were at historic lows, many investors ventured away from cash holdings in search of higher yields. Certificates of deposit (CDs) and money market funds were barely keeping pace with inflation. But with interest rates climbing steadily over the past two years, now may be a good time to rethink your cash position.
Why interest rates matter
Rising interest rates can have an adverse effect on some of the investments in your portfolio. For example, bonds typically lose value when interest rates rise. That’s because new bonds sold today may offer higher yields than the bonds you purchased last year.
The stock market may also react negatively to interest-rate increases. When companies have to pay more to borrow money, corporate earnings tend to suffer. This can lead equity investors to exercise added caution.
Interest-rate hikes have the opposite effect on cash investments. When rates go up, yields on money market funds and CDs generally rise in sync. CDs typically offer better rates than money market funds, but they lock up your money for a set number of months or years, and they impose a penalty for early withdrawals. That’s something to keep in mind if you expect rates to continue rising.
Money market funds are neither insured nor guaranteed by the FDIC or any other government agency. Although a money market fund attempts to maintain a stable $1 share price, you can lose money by investing in a fund. Ask your financial professional for a prospectus, which contains information you should read about the fund’s investment objectives, risks, and expenses. The FDIC insures bank CDs, which generally provide a fixed rate of return.
Of course, a portfolio that is too heavily weighted in cash may not be the best scenario either. Over time, both stocks and bonds have historically outperformed cash equivalents, and they generally experience greater volatility, according to Thomas Financial study from 1985-205.
A well-balanced portfolio might diversify your investments over many different asset types, allowing you to manage risk and weather market volatility. Diversification does not guarantee against loss; it is a method used to help manage investment risk.
Since the tech boom of the late 1990s, interest-rate fluctuations have kept investors on their toes. Today’s interest rates may prompt some individuals to give cash a greater role in their portfolios.