Americans chasing high interest rates risk falling into a ‘cash trap’

The 66-year-old retired banker and his wife have about 60% of their nonretirement assets in Treasury bills and money-market funds that are paying yields of around 5%. With plans to buy a second home in a warmer area, they expect to keep it there until the Federal Reserve cuts short-term interest rates to 4% or below.

“Until then, I’m just going to keep it in cash. I like the safety," said McGovern, of Grosse Pointe Woods, Mich.

Americans have poured money into cash-like investments since the Fed began raising interest rates, driving assets in money-market funds to a record $6.12 trillion earlier this month, according to the Investment Company Institute. Now, Wall Street traders are betting rates have peaked and those investors face a choice: keep sitting on their cash as interest payments shrink, or figure out how to redeploy the money.

Deciding when and how to rebalance a portfolio is challenging even for pros, and depends on factors including a person’s age, savings and expected needs. But staying on the sidelines risks missing out on years of potential gains from holding a broad portfolio of stocks, bonds and other riskier investments.

J.P. Morgan Asset Management calls it the “cash trap."

“If you’ve owned cash for the last year and a half, that view in the rearview mirror is pretty attractive and you feel good about yourself," said John Croke, head of actively managed bond products at Vanguard. “But you have to remind yourself that that’s the rearview mirror."

Croke said long-term investors should return to a diversified bond portfolio so they can lock in attractive long-term yields before the Fed starts cutting rates. Savers might find that hard, with short-term rates at 5.25% to 5.5%, their highest level in two decades.

Further complicating decisions about when to reallocate cash: Wall Street has repeatedly been wrong about the path of interest rates, with investors earlier this year betting the Fed would cut as many as six times in 2024. People who are going to need their money sooner may also see bigger stock allocations as too risky.

Jean Mersch, 61, an accounting manager for a commercial printer in Minnesota, said a third of her and her husband’s retirement assets is in money-market funds. That includes a few hundred thousand dollars tucked away in a high-yield savings account earning about 4.5% interest.

“If we get back to where there were no high-yield savings accounts that were paying much more than 1%, then we might look at some stuff and try to figure it out," Mersch said.

Given their substantial retirement savings, Mersch doesn’t mind if the cash portion doesn’t earn large returns. She would consider diversifying more if the Fed starts cutting rates aggressively and the stock market takes a big fall.

The decision could cost her over the long run. Since the end of 2021, the Vanguard Federal Money Market Fund has returned 9.1% through the end of May. The S&P 500, meanwhile, rose 15.1% over the same period when including price changes and dividend payments. The Bloomberg U.S. Aggregate bond index has lost 9.7%, according to Dow Jones Market Data.

Another problem with holding long-term investments in cash: Inflation is likely to chip away at its value after three years, said Cody Garrett, a financial planner at Measure Twice Financial.

Taxes and fees can eat into returns as well. Interest payments from money-market funds are generally taxed as ordinary income, not at the usually lower rates for dividends or capital gains.

Money-market funds also tend to charge higher fees than stock-index funds.

“Investors who are maintaining large cash balances are basically taking a very one-sided position that rates will not go lower," said Richard Saperstein, chief investment officer at Treasury Partners, which manages $12 billion in client assets.

Some investors cite reasons other than attractive interest rates for sticking to cash. Frank Hammond, a 72-year-old retiree in Pittsburgh, said he is nervous about November’s presidential rematch between President Biden and former President Donald Trump. Geopolitical tensions, including escalating conflicts in the Middle East, are another reason for worry.

“If rates go below 4%, it won’t trigger me," he said. “I think that we’re in for some real turbulence in the markets."

Hammond said he has 25% to 30% of his retirement assets in a money-market fund, up from about 15% a few weeks ago.

The anxiety is understandable, because global instability can lead to market volatility. But investors shouldn’t try to time the markets or invest based on their emotions, said David Kelly, chief global strategist at J.P. Morgan Asset Management.

“People generally feel negative and pessimistic," he said. “If they invest based on how they feel, they are going to hang on to cash forever."

Write to Vicky Ge Huang at vicky.huang@wsj.com