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 Most investors will tell you that there are three basic types of investments you can make - stocks, bonds and cash. But there are some people that treat cash as something you only need to have on hand for those unexpected expenses. But as we shall see, cash can and should play an important role in nearly everyone's mix of assets in their portfolio.
Cash Assets
There is no doubt that having cash around as "spending money" is a necessity for most of us. We need cash to pay our monthly bills and we might also like the idea of having some extra money handy in case an unexpected expense arises. Those are two pretty compelling reasons to have and hold cash.
Asset Allocation
But there are other reasons to hold onto cash - even beyond those "rainy day" expenses. In fact, asset allocation theory tells us there are several factors that drive our need to hold cash for example:
- Years Until Retirement - actually this factor should read more like - years until the money is needed. The point here is that the closer you are in time to needing money, the more liquid the investment should be.
- Risk Tolerance - if you're the type of person that panics when their investments are performing poorly, then you're a good candidate for investing in cash.
- Knowledge and Comfort with Alternative Investments - unfortunately for some of us, we are limited in our investment choices due to lack of knowledge - we simply don't know how to invest our money elsewhere so we hold cash and in this example, probably in excess.
Asset Allocation Calculator
You can see how these factors influence the amount of cash held in portfolios by running through some planning scenarios with our asset allocation calculator. Your response to six simple questions allows the calculator to figure out your risk tolerance score and provide a recommended mix of assets including stocks, bonds and cash.
Advantages of Cash Investing
The primary advantage of cash is preservation of capital. That's a fancy way of saying cash is a very safe investment. If you place you money in Money Market Funds or Certificates of Deposit then you might even be covered by the Federal Deposit Insurance Corporation, which means your deposit is insured against loss.
Another advantage of cash is that it prevents you from liquidating assets from other classes - such as stocks or bonds - when you've got a large expense coming up. The last thing you want to do is have to sell a portion of your stock portfolio during a bear market so you can pay for your daughter's wedding. Holding cash is a simple way to meet these types of financial obligations.
Cash investments are also extremely liquid assets - that means they can be quickly exchanged for products or services we need. In fact, in most cases all we need to do is make a simple withdrawal from an account to have immediate access to our money.
Disadvantages of Cash Investing
On the other hand, the primary disadvantage of cash has to do with the overall return on investment. The higher rewards in life usually go to those that are willing to take greater risks and that means that relatively safe investments such as cash will provide relatively low returns.
This is one of the reasons that many investors spend so much time trying to figure out how much cash they need on hand. Investing is like putting our money to work for us and if too much money is sitting around idle then we cannot help but feel that we missing out on greater returns.
Where to Invest Cash
If you're convinced that cash can, and should, play an important role in your investment portfolio then you've really got four options when it comes to cash investments:
- Certificates of Deposit
- Money Market Mutual Funds
- Money Market Accounts
- High Yield Checking Accounts
Certificates of Deposit
If you're an investor searching for a relative low risk investment, then certificates of deposits, or CD, might be of interest to you. A CD is nothing more than a deposit account with a thrift institution or bank that typically offers a higher rate of interest than a savings account. CDs typically carry federal deposit insurance coverage up to $100,000.
Purchasing a CD
With a CD you are investing a fixed amount of cash for a fixed period of time. The more common terms you'll find for a CD include 3 months, six months, one year, three or five years. Interest is paid on a CD at predetermined intervals - usually monthly. CDs that are redeemed early are usually subject to an early withdrawal penalty.
Before buying a CD makes sure you understand all the terms and conditions associated with the deposit, including:
- Maturity Date - find out when the CD matures, most banks will provide this information in writing.
- Early Withdrawal Penalties - find out what early withdrawal penalties exist, such penalties are usually stated in terms such as the forfeiting of interest payments.
- Callable CDs - a callable CD gives the bank the right to call in the CD after a set period of time. So if interest rates suddenly fall, the bank can call in the CD which means you need to move your cash elsewhere at the most undesirable time.
- Brokered CDs - if you're planning on investing a lot of money in CDs, then you need to understand if the CD deposit is being brokered. FDIC insurance is on a per institution basis with a limit of $100,000 so you'll want to make sure all of your CDs are not with the same financial institution.
Money Market Mutual Funds
Money market mutual funds are mutual funds that invest in short-term debt instruments. Money market funds invest in certificates of deposits, government securities, commercial paper of companies, and other low-risk, highly-liquid securities. And unlike other mutual funds, they attempt to keep their net asset value (NAV) at a constant $1.00 per share.
If you're looking for information on money market funds, then check out our article on Money Market Mutual Funds. There you'll find lots of information about this low risk investment along with a list of some of the top funds in terms of yield.
High Yield Checking / Money Market Accounts
Although the exact rules may vary slightly with respect to high yield checking accounts and money market accounts but for most of us these two investments are nearly identical. These types of accounts are typically offered through local banks and allow you to write checks.
In exchange for offering higher yields than savings accounts, high yield checking and money market accounts normally have fairly high minimum balance requirements. There may also be restrictions with respect to the number of transactions allowed each month - such as the number of checks written. You may be subject to penalties if you exceed these thresholds. Banks limit the number of transactions so they can invest the money in higher yield areas.
The important point here to remember is simply this: before investing your cash in any of the above mentioned accounts make sure you understand all of the funds terms and conditions. Ultimately it's your money and you need to understand all the rules associated with gaining access to that money.
About the Author - Cash Investments
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