The consumer inflation rate is currently just less than 2%. Sounds pretty benign, doesn’t it? Well, it isn’t if you are keeping large sums of money in the bank at today’s interest rates. In fact, “safe” money in bank accounts and money-market funds is subject to erosion just as surely as any stock-market decline might affect your investment portfolio.
We all know that interest rates on bank deposits, money-market funds and short-term U.S. Treasury Bills are hovering close to zero. And the Federal Reserve Board, which manipulates short-term interest rates in order to achieve its dual mandate of low inflation and full employment, has vowed to keep interest rates at current levels for the time being.
In spite of this, frightened investors are sitting on a ton of cash, even as they worry about the threat of inflation, as well as recent terrorist activities. Many investors have much of their portfolio in cash because they are scared to invest in a volatile market environment. The cost of that perceived safety is a decline in purchasing power. As each day passes and inflation rises, money held at the bank will purchase fewer goods and services.
Everyone should keep some cash in bank deposits or money-market funds as a safe emergency fund. However, it is detrimental to your wealth to hold too much excess cash these days.
Savers have two good alternatives for their excess cash.
- Use some excess cash to pay down debt. Almost any loan today, from a mortgage to a credit-card balance, is charging more interest than you are making at the bank.
- Invest some of the cash into a diversified portfolio that includes stocks and bonds. Yes, you will have to bear market volatility, but higher rates on bonds and capital appreciation on stocks will give you a fighting chance to beat inflation.
Do not confuse short-term investment fluctuations with long-term investment returns.
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