Holding too much cash can be a mistake, experts say

It wasn’t long ago that investors earned practically 0% returns on cash.

As the Federal Reserve has kept interest rates high to combat high inflation, you can easily earn 5% annual percentage yields on savings accounts and other low-risk vehicles.

Some experts are now warning it’s possible to get too comfortable with those super-safe returns and miss out on bigger market returns.

“We’re too obsessed with cash,” Callie Cox, chief market strategist at Ritholtz Wealth Management, wrote last week in a blog post.

An estimated $6 trillion in cash is parked in money market funds.

Industry research finds younger investors — those with the longest time horizon to absorb risk — are allocating the most to cash.

More from Personal Finance:
Is the U.S. stock market too ‘concentrated’?
Americans struggle to shake off a ‘vibecession’
Retirement ‘super savers’ have the biggest 401(k) balances

More than half — 55% — of wealthy younger investors ages 21 to 43 ramped up their cash allocations in the past two years, compared to 46% of individuals ages 44 and up, recent research from Bank of America found.

While Bank of America focused on investors with at least $3 million in investable assets, trading and investment platform eToro earlier this year found younger investors are twice as likely as their parent’s generation to have increased their cash assets. The eToro survey polled 1,000 U.S. retail investors as part of a bigger pool of 10,000 in 13 countries, and respondents held at least one investment product.

“The bigger issue that not enough people are talking about is the fact that younger investors are over-allocating the cash because of the allure of the 5% savings rate,” Cox said in an interview with CNBC.com.

“Under-investing is a risk, and it’s one that I think more younger investors are susceptible to,” Cox said.

Long term, a 5% return can fall short of the potential gains investors can earn in stocks. A more aggressive portfolio allocation to stocks may yield a 7% average annual rate of return. In some years that will be higher and in some lower.

The S&P 500 index may climb to 5,800 by the end of this year, bringing its total return to more than 20% for the year, Thomas Lee, managing partner at research firm Fundstrat Global Advisors, told CNBC’s “Squawk Box” on Monday.

That would follow a 24% return for the index in 2023, he noted, bringing the total for both years to around 50%. That would be “painful” for cash investors who missed out on those gains, as it would take them 10 years to achieve the same results, Lee explained.

“I think the end of this year is a little bit of a day of reckoning for those who have said, ‘Oh, I’m happy with my $6 trillion in cash earning 5%,’ when in reality, unless the economy is rolling into a recession, the expansion could continue for some time,” Lee said.

Not all experts are as optimistic, however.

The S&P 500 may fall more than 30% later this year if a recession hits, research firm BCA Research predicts.

Of course, all investors should have some cash set aside, experts say. Financial advisors generally advise having at least three to six months’ worth of expenses in cash in case of an emergency.

Research often shows many Americans fall short of that goal. Americans have a median emergency savings of just $600, according to a recent survey from financial services company Empower.

Of Americans who do have cash savings, 67%, are still earning less than a 4% annual percentage yield, Bankrate recently found.

For goals one to two years away — or even three to five years away — it makes sense to allocate cash to make sure the money is there when you need it, according to Cox.

“But anything beyond five years, I would seriously consider putting that money into stocks or other more risky assets,” Cox said.

Fear may be one reason why investors are tempted to sit on the sidelines in cash now.

But the risk of missing the market upside may be the bigger opportunity cost, experts say.

“Market timing is truly a fool’s errand, but lack of participation in the market is also foolish, particularly for long-term investors,” said Mark Hamrick, senior economic analyst at Bankrate.

While there’s always the possibility the markets could continue to go up indefinitely or plunge 50%, those are the edge cases, Cox said.

“You could be waiting a long time for that pullback if you just sit in cash,” Cox said.

The biggest risk for investors now is missing another leg of this rally, she said.

The environment for cash savings may be poised to change, as the Federal Reserve has signaled plans to eventually start cutting interest rates as inflation subsides.

That may make a 5% return on cash a thing of the past. Savers may lock in five-year certificates of deposit at today’s rates, Hamrick said. But they should be aware that they will need to pay a penalty if they want to access that money sooner than five years, he said.

“Yields for CDs, high-yield savings accounts, money market accounts and the like will remain elevated,” Hamrick said. “Rates are likely to come down, but not fall like a rock, rather fall like a feather.”