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What About Cash?

Key Points
  • 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

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.

Two Types of Annuities for Retirement Income
Two Types of Annuities for Retirement Income
Emerging Markets: What You Should Know

Important Disclosures

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.


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