Cash in summary:
- Have enough cash through your savings/checking accounts and the cash in your brokerage account to cover at least 3 months of your monthly expenses. This amount of cash should remain in your accounts, and the additional money you have saved will be for investing in riskier assets
- Cash investments are not risk-free
- Returns are generated from interest payments only, which are taxed at your marginal income tax rate Interest rates these days are pitiful so you will not be rewarded for keeping significant amounts of cash
- Accept the automatic “cash-sweep” option in your brokerage accounts to avoid trading costs, or just keep the extra cash in your checking account
Cheddah, bricks, green-backs, dough, bread, cake, ducketts, dead-presidents … whatever you wish to call it. But in the investment world you rarely actually hold cash in your accounts, but rather “cash-like” instruments. Whether you choose a cash investment or just keep an extra amount stored in your checking account, it is a good strategy to always have enough cash on hand to cover at least three months of your normal expenses. This “buffer” will shelter you from the risk of having all of your money invested in a volatile investment and needing money when your investments could be performing poorly. Holding slightly higher levels of cash may be prudent for those with variable income to protect you from the risk of a short-term gap in income or losing your job altogether.
You may be familiar with “cash-like” products such as money market funds, or stable value funds from your work’s retirement savings plan. These funds primarily invest in a multitude of high-quality short-term debt instruments from corporations and/or governments generally that are repaid on average within 90 days or less to keep their investments liquid (aka quickly convertible into cash). Their goal is to maintain the value of each share you purchase in the fund at $1.00 – thereby not providing any gains or losses but just a yield from the underlying investments in the form of interest payments (usually monthly).
Once seen as just as safe as holding the green-stuff, these funds provided an attractive investment for investors looking for higher yield above their checking accounts. The problem though began once investors took extra risk for just a few extra basis points (0.01 percent = 1 basis point) of return. This led to these funds investing in riskier companies and in some cases creating new investing formats to give investors a higher return on their “cash”.
At the height of the financial crisis when investment bank Lehman Brothers declared bankruptcy in September 2008 these once very reliable and liquid investment options showed the risks of reaching for this extra return. The Reserve Primary Fund, the first money market fund ever created, had to write-off the value of their investment losses in Lehman Brothers when the firm entered bankruptcy. This caused the fund to “break-the-buck” – which means investors in the fund actually lost about 3 percent on their investment. What was more significant was the loss of liquidity in many of these funds as a result which forced some investors to wait months and in some cases over a year to get billions of dollars returned to them. Although only one major fund “broke-the-buck” many other money market funds could have lost value had their parent companies not stepped up to support them. The lesson here is being that there is no free lunch – if you chase a higher return you will almost certainly be taking on a higher risk.
So if you need to hold a sizable amount of cash, say to have money on hand for the near-term goal of a down payment on a home, just keep it simple. Due to current economic conditions and Federal Reserve policies, many of these funds will likely not be able to provide a yield over 1.00 percent, so don’t look to make money here. Look for money market funds with low expense ratios with a strong company to support them if they find themselves in trouble. The interest you earn on this money market fund, or any other bank account interest, is taxed by the federal and state government at your marginal tax rate.
In your brokerage account when you deposit cash the money will normally automatically “sweep” into a fund or money market to provide some yield on this cash (instead of your money sitting in the account uninvested). Many brokerage firms now have a banking unit and this cash “sweeps” to their bank division instead of a money market fund. This is a major source of revenue for brokerage firms since they will usually pay less interest than the money market fund universe and keep that extra interest for themselves. But, they “sweep” any extra cash into the deposit fund for free. When you want to invest in a money market fund, you will have to pay trading costs to buy into and to sell out of the fund. This trading cost of up to $20 in many cases will be more than the extra yield you will receive in a money market fund, so in many cases, you will be better off just holding the automatic “cash-sweep” option that many firms provide free of charge.
Or, perhaps even better yet, just keep your extra cash reserves in an FDIC (Federal Deposit Insurance Corporation) insured checking or savings account from which you have immediate access to. Currently, your deposits at most U.S. banking institutions are insured by the FDIC of up to $250,000 per depositor at each bank. Thus, if your bank goes bust then the FDIC will make you whole on your money up to $250,000.