What About Cash?
November 21, 2012
- There's always a role for cash in your portfolio. How much, and what role, depends on your investment needs.
- Cash and cash investments can be useful for liquidity, flexibility and stability.
- While cash rates remain near zero, returns will almost certainly rise with interest rates or inflation.
Is cash "trash" or is it "king?" You may hear it referred to as either, depending on the investment climate, or you may even hear both points of view at the same time. Which is correct? As usual, the answer depends on your situation and financial needs.
Today, returns on cash and cash investments hover near zero. For some portions of your portfolio, however, what matters more is safety, as well as keeping up with inflation, which currently is also near zero.
But how much cash is enough, or too much? Keeping too much money in cash while waiting for opportunities to enter a market, or out of simple fear of the investing climate, can be costly. If you're invested for the long term, returns on cash probably won't keep up with the alternatives. And, it's very difficult to time markets.
Try to remember that cash comes in handy when you need it. It can also support your portfolio and help meet long-term objectives. So know when cash can help you, and handle it with care.
What is cash?
Many people think of cash as physical currency—actual bills and coins in circulation. For practical purposes, however, the term "cash" also includes traditional bank deposits, such as checking and savings accounts, where you generally have access to your funds on demand and without risk of losing any principal (up to FDIC limits).
In an investment context, however, the definition of cash expands to other types of cash investments, including short-term, relatively safe investment vehicles such as money market funds, US Treasury bills (T-bills), corporate commercial paper and other short-term securities.
Why hold cash and cash investments?
Let's look at three broad reasons for maintaining a cash or cash investment position as part of a financial plan.
Reason 1: Liquidity
Apart from day-to-day expenses, the need for liquidity generally falls into two categories:
- Emergencies (health problems, lost job, etc.)
- Known obligations or likely expenses in the next one to three years
For emergencies, consider setting aside an "emergency fund" of cash equal to at least three months' worth of non-discretionary spending, though the actual amount could vary depending on job outlook and other sources of income and credit.
Then consider setting aside money for known obligations you might pay from cash reserves (instead of current salary or other monthly income). These can include quarterly estimated income taxes, property taxes, a down payment on a home, a child's wedding, college bills, a vacation and so on.
Unlike the emergency reserve, which is intended for the "just in case," think about cash that's set aside to cover known obligations as money that's already spent.
Liquidity is extremely important here—don't invest money reserved for short-term obligations in the stock market. Instead, keep it in cash, cash investments, or shorter-term investments with minimal principal risk between now and when you need to spend the money.
Liquidity for retirees
Retirees typically have special liquidity needs such as increasing medical costs. For example, the need for emergency funds may diminish somewhat, as job loss becomes less of a concern. However, it may make sense to set aside enough cash to cover at least 12 months' living expenses to provide cash for spending and limit pressure to sell from the portfolio at an inopportune time. Use this for current expenditures, not the rest of your portfolio.
Beyond that, consider keeping another two-to-four years' worth of expenses in shorter-term investment alternatives (short-term bonds, CDs and so forth) as part of the fixed income portion of your retirement portfolio. That way, during a bear market, you could avoid having to liquidate other assets during the worst possible time.
Reason 2: Flexibility
By holding a percentage of your portfolio in cash, you can take advantage of investment opportunities as they arise. A cash allocation may come in handy if you wish to slightly overweight or underweight certain asset classes in your portfolio based on your outlook for the markets.
In addition, a cash allocation can provide flexibility when it's time to rebalance your portfolio and/or pay investment fees. You might also use excess cash to buy on dips when markets fall, or replenish your cash cushion when markets rise.
Reason 3: Stability
Bonds have been the traditional choice when seeking to reduce a portfolio's overall risk. They have tended to perform differently than stocks in the same market conditions—sometimes moving in the opposite direction.
Historically, however, cash investments have been even less correlated with stocks. What's more, cash investments are, on average, far less volatile than long-term bonds. The big advantage of bonds, of course, is potential for higher income. That said, in the appropriate proportion, cash and cash investments can help to stabilize investment portfolios over time.
After you've set aside money for emergencies and known obligations, investors may consider including some cash in their long-term portfolios. The actual percentage will depend on time horizon and overall risk tolerance.
For this role, cash investments are meant to be the more defensive part of a portfolio. Don't take too much risk for a bit of extra return here. Risk is generally best left for the more aggressive portions of a portfolio.
Concerned about low cash rates today?
If you're worried that your cash and cash investments aren't providing adequate returns, remember that cash should be more about safety than income or risk for higher returns. It's also important to keep in mind that today's rates on cash investments of any kind are generally low because the Federal Reserve continues to keep interest rates near record lows. This keeps returns on most cash investments low, as well.
If interest rates rise, returns on cash investments tend to rise quickly, as well. When the Fed raises rates due to economic recovery or because inflation begins to rise, rates on cash investments tend to follow soon after.
The chart below helps illustrate this. The fed funds rate, the Fed's main tool to control rates on everything from cash investments to long-term bonds, is essentially 0%. As the Fed has adjusted rates in the past, returns have followed very closely.
Today, inflation remains very low. But it's one of the main issues watched by the Fed, along with the health of the economy, when deciding when rates will rise.
Rates on cash investments track closely to Fed interest rate policy
Source: Bloomberg, Morningstar. Rolling 12-month cash investment returns represented by Citigroup three-month Treasury bill index. The darker-shaded areas on the chart represent periods when the Federal Reserve was tightening monetary policy by increasing the Fed Funds rate.
Where can you keep your cash?
Whatever your reasons for holding cash, you need a place to put it.
Consider these alternatives:
- Checking, savings and money market accounts are options for day-to-day expenses as well as the emergency reserve.
- Shorter-term CDs and T-bills can be used as part of a strategic cash investment allocation and are also useful for known obligations coming due in the next three to 12 months. These investments, with their fixed maturity dates, aren't as liquid as the alternatives in the first bullet. Ideally, the maturity of the CD or T-bill could match up with that of any known obligation.
- Longer-term CDs can be used as part of a strategic cash investment allocation or for known obligations coming due within one to three years.
|Investment||Liquidity||Market Value||Credit Quality|
|Checking and savings accounts||Immediate||Stable||FDIC Insured|
|Sweep Money Market funds||Immediate (may be limits on writing checks)1||Stable||Credit quality of portfolio investments subject to Rule 2a-72. Not FDIC insured|
|Purchased Money Market funds||Generally available next business day after sale||Stable||Credit quality of portfolio investments subject to Rule 2a-72. Not FDIC insured|
|T-bills||Available at maturity||Fluctuates prior to maturity||Backed by the US Treasury|
|Certificates of Deposit (CDs)||Bank CDs may have penalties for early withdrawal ; brokered CDs may be thinly traded on secondary market||Stable (brokered CDs may change value if sold prior to maturity)||FDIC insured|
The type of investment, along with how much cash to set aside, is dependent on each investor's situation and preferences. Whatever the investment vehicle, consider using cash or cash investments to help build toward longer-term objectives.
1. Subject to account agreement
2. Rule 2a-7 of the Investment Company Act of 1940 mandates that money funds limit their investments to securities with maturities of 397 days or less, that they maintain a weighted average maturity (WAM) of 60 days or less, and that they maintain a weighted average life (WAL) of 120 days or less. Money funds also may only invest in high quality securities—those with the highest short-term ratings—and are subject to minimum diversification and liquidity requirements.
Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.
An investment in a money market fund is not a bank deposit and is neither insured nor guaranteed by the FDIC or any other governmental agency. Although money market funds seek to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in these funds.
Investment value and return will fluctuate such that shares, when redeemed, may be worth more or less than original cost.
Past performance is no guarantee of future results.
Certificates of deposit are offered through Charles Schwab & Co., Inc. CDs from Schwab CD OneSource are issued by other FDIC-insured institutions, and are subject to change and system access. Unlike mutual funds, certificates of deposit offer a fixed rate of return and are FDIC-insured. There may be costs associated with early redemption and possible market value adjustment.
The temporary increase of FDIC insurance coverage to $250,000 for all insurable capacities has been extended through December 31, 2013. If not further extended, FDIC coverage will revert to $100,000 on January 1, 2014 for all insurable capacities except IRAs and certain other self-directed retirement accounts and plans. Unless the increased coverage is extended, deposit insurance coverage for CDs with a maturity date after December 31, 2013 will revert to the prior FDIC coverage on January 1, 2014, regardless of when you purchased the CD. You should not rely on a possible extension of this increased coverage in purchasing CDs.
This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue any investment strategy. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. Opinions expressed herein are subject to change without notice in response to shifting market conditions.
The information contained herein is obtained from sources believed to be reliable, but its accuracy or completeness is not guaranteed.
Indexes are unmanaged, do not incur management fees, costs and expenses (or "transaction fees or other related expenses"), and cannot be invested in directly.
Citigroup U.S. 3-month Treasury Bill index measures monthly total return equivalents of yield averages that are not marked to market. The Index consists of the last three three-month Treasury bill issues.
Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc