Special Report on Investments and Personal Finance : Short-Term Yields Have Allure, But Don’t Over-Commit

At times like this, it’s tempting for some investors to keep much or most of their financial assets in short-term “cash” accounts such as bank CDs or money market mutual funds.

Avoid the temptation, at least with that portion of your investments that is truly long-term in nature.

Though short-term accounts are safe and now pay the highest yields since 1991--you can earn 6% or better on one-year CDs, for example--over any long-term period, a low-risk cash investment always earns less than stocks and bonds.

Think of this as a sort of law of nature. “People who invest in stocks have to be rewarded for that extra risk,” says Derek Sasveld, consultant at Ibbotson Associates in Chicago, which tracks investment returns.

Cash returns have lagged stock and bond returns over the past five, 10 and 25 years. The average annualized return on blue-chip stocks has been 12.1% since 1970, for example, while long-term Treasury bonds have returned 9.4% and cash (30-day Treasury bills) has returned 7.1%.

The relationship holds for the last 70 years as well, through higher and lower interest rates and stock market booms and busts, Sasveld notes.

Cash looks even less alluring, he says, after accounting for inflation and taxes.

Interest earned on a CD is taxed at ordinary rates, which are higher than tax rates on any long-term appreciation of your stocks. And a CD, which pays a fixed return, doesn’t offer the inflation protection you can get through periodic increases in the cash dividends paid on stocks.

Of course, if you could time the stock and bond markets perfectly--buying at lows and selling at peaks--keeping all of your assets in cash during market downturns would produce the best returns of all.

But few people, even professionals, can time the market well. The risk of selling all of your stocks when the market seems high and then moving into cash is that you’ll never get back into stocks in time to catch the next big move up.

So what should you keep in cash accounts? Money that you may have to spend over the next two to three years. Emergency funds. However much you need to feel diversified and safe--in other words, enough of a cushion to keep you from feeling panicky when your stocks take a short-term dive.

But if you think about your long-term goals--and keep historical returns on stocks, bonds and cash in mind--you may well decide to keep cash to a minimum.

The Case Against Cash

Over a long-term period--five, 10 or 25 years--low-risk”cash” investments such as money market funds consistently return less than stocks and bonds. Average annualized returns by period: