Revisiting Cash Asset Assumptions: Updated Returns and Volatility in a Changing Market

Periodically, Nitrogen conducts a review of the rate and volatility assumptions for the asset type classified as “Cash.” The category includes a broad range of cash-like instruments or cash equivalents, such as certificates of deposits (CDs), savings accounts, money market instruments, high-yield savings accounts, money market deposits, cash sweep assets, money market mutual funds, and of course cash.  

Each of these instruments carries its own historical return and volatility. Traditionally, the yield differences between them have been minimal, making it reasonable to assume an annual return of 0.842% (or a 6-month equivalent of 0.42%) with zero volatility. However, the spread between these products has measurably widened in recent years, and current rates for some cash equivalents are much higher, though not universally so.

As mentioned above, the current assumption is a 0.42% 6-month return with zero volatility. The illustration in Figure 1 shows that the rate spread between various cash equivalent instruments began to widen in mid-2022. Instruments like money markets and treasury yields have seen significant increases. However, others, such as interest-checking, money market deposits, and savings rates, remain at or below Nitrogen’s current rate assumption. 

Source:  Federal Reserve Bank of St. Louis and SEC.gov

By applying Nitrogen’s annual average return calculation to the 30-day treasury yield (shown in Figure 2), the result is a 1.5% average annualized return with a 1.64% annualized volatility.  If this calculation is performed for the time period prior to the interest rate increase starting in June 2022, the annual average return is 1.12% with 0.75% volatility.  As you can see in the chart, and as these figures demonstrate, volatility has increased noticeably over the past two years. 

Source:  Federal Reserve Bank of St. Louis

To better align with this data, Nitrogen is increasing the cash return and volatility assumptions to better reflect the broader range of securities included in the “Cash” category. While some security types are currently yielding 5% and higher, others are not. The overall average must account for this disparity. The cash return is being updated to an annual average return of 2.95% with an annual volatility of 1.25%. This adjustment allows for a more accurate representation of the various instruments included in the cash classification. As market conditions evolve, particularly if interest rates decline, Nitrogen will reassess and potentially lower these yields to maintain accuracy.

In addition to these updates, the return on cash is now included in the annual dividend.   Previously, any yield or return from cash was not reflected in an account’s or portfolio’s dividend yield.

What impact does this change have on accounts that hold cash?

The updated assumptions have a modest impact on the overall Risk Number for portfolios and accounts holding cash. In general, increasing the cash return may reduce the Risk Number, improve the GPA, and raise the annual return midpoint. For accounts or portfolios with a large cash balance (over 50%), this change results in a modest reduction in the overall Risk Number. Accounts with lower cash balances are unlikely to see any impact to the Risk Number or GPA. The change also results in a wider distribution for the 95% range; a higher best case and a lower worst case with a higher average return. The table below demonstrates the impact on certain metrics based on the level of cash. The non-cash portion of the portfolio in these examples is allocated 50/50 between SPY and AGG.   

This update reflects Nitrogen’s commitment to ensuring that our assumptions align with current market conditions and the evolving nature of cash and cash equivalent instruments. By adjusting the return and volatility metrics, we aim to provide a more accurate representation of the potential risks and rewards associated with holding cash in a portfolio. As always, Nitrogen will continue to monitor market conditions and make adjustments as necessary to maintain the accuracy and relevance of our assumptions.