Cash and equivalents serve several purposes in a diversified portfolio, including portfolio stabilization during market volatility, reserves for portfolio rebalancing during market declines, and emergency funds for surprise expenses (so an investor can avoid selling out other assets, as well as potential fees and taxes associated with gains).
The primary advantage of cash or cash equivalent investments is liquidity.
Money held in the form of cash or cash equivalents can be quickly and easily accessed. A “pile of cash’ is important for portfolio risk management, and should be incorporated into one’s investment strategy.
- Outline cases for and against cash holdings
- Define cash equivalents
- Explore portfolio construction with cash & cash equivalents
Cash is King … Cash is Trash
The obvious argument against a large cash position is that fiat currencies lose purchasing value over time due to inflation, with cash often seen as a lost investment opportunity.
In fact, the U.S. Dollar lost half its purchasing power from 1990 to 2018. What’s more, $100 in 1913 had the same purchasing power as $2,529 in 2018. That’s scary… loss of value happens quickly in fiat currencies. It is important to remember to balance cash allocations against the high volatility seen in stocks, commodities, income, and other asset classes in your diversified portfolio.
Cash equivalents are assets with cash-like properties, but which sacrifice one element, such as liquidity, for yield. Cash equivalents include:
- Money Market Funds
- Certificates of Deposit (CDs)
- U.S. Savings Bonds
Money Market Funds
There are several types of money market funds, which are investment vehicles for pooling assets of very short-term, liquid, highly-rated bonds. Money market funds primarily invest in government securities, tax-exempt municipal securities, or corporate and bank debt securities.
Certificates of Deposit (CDs)
A type of federally insured savings account that has a fixed interest rate and fixed date of withdrawal, known as the maturity date. CDs typically pay higher interest than regular savings accounts, with longer term maturities producing higher interest rates. Although investors have traditionally purchased CDs through banks, brokerage firms also offer CDs.
The primary issue with CD investing is lack of liquidity (beyond counterparty risk, of course). To decrease interest rate and reinvestment risks arising from this lack of liquidity, a strategy known as CD laddering was developed.
Treasuries issued by the federal government to finance its budget deficits. Not only are Treasuries considered credit-risk free, as they are backed by the full faith-and-credit of the U.S. government, but they are also extremely liquid. There are additional tax benefits for U.S. residents as well. Treasuries with maturities under one year are called Treasury bills. These bills have low risk, low yields, and low interest rate exposure. Also consider that the recent rate inversion puts T-bills at the same yield or better as long-term Treasuries (March, 2019).
U.S. Savings Bonds
Savings bonds are debt securities issued by the U.S. Department of the Treasury to help pay for the U.S. government’s borrowing needs. U.S. savings bonds are considered one of the safest investments because they are backed by the full faith-and-credit of the U.S. government. As of Jan. 1, 2012, an investor can no longer purchase paper savings bonds at financial institutions, but they can be purchased online. Types of U.S. Savings Bonds include Series EE and Series I.
Risk should be avoided for this portion of a diversified portfolio. Credit risk, default risk, call risk, currency risk, political risk, counterparty risk, and liquidity risk make some currencies and cash equivalents inappropriate for proper diversification. Remember: not all cash equivalents are equivalent, and yield should not be chased in this asset class.
In this asset class we do not seek diversification within the asset class, rather diversification to this asset class.
So, What’s the Point?
As with stocks, income assets, and commodities, in terms of correlations to one another, there is clearly no need to invest in many cash or cash-equivalent assets – many holdings do not provide additional asset protection. In consideration of investment simplicity, low management time, little research time, reduced complexity in portfolio rebalancing, and a potentially small starter stash for building our diversified portfolio, the author is choosing…
Get the book What is Investment Diversification? to learn which investments were selected and why.
Now, let’s take a look at cryptocurrencies in the next study guide.
Certificate of Deposit (CD)
A type of federally insured savings account (FDIC insurance) that has a fixed interest rate and fixed date of withdrawal, known as the maturity date.
The likelihood or probability that one of those involved in a transaction might default on its contractual obligation.
Money Market Fund
Investment vehicle for pooling assets of very short-term, liquid, highly-rated bonds. Money market funds primarily invest in government securities, tax-exempt municipal securities, or corporate and bank debt securities.
Debt securities issued by the U.S. Department of the Treasury to help pay for the U.S. government’s borrowing needs.
Treasuries are issued by the federal government to finance its budget deficits.
Treasury Money Market Fund
A United States Treasury money mutual fund is a mutual fund that pools money from investors to purchase low-risk government securities.
- CD laddering https://www.investopedia.com/terms/c/cd-ladder.asp
- SEC: “High-yield CDs: Protect your money by checking the find print” https://www.sec.gov/reportspubs/investor-publications/investorpubscertifichtm.html
- Slightly dated, but a good starting point for research into available yields and CD offerings https://www.nerdwallet.com/blog/banking/nerdwallets-best-cd-rates/
- More on savings bonds from the SEC https://www.sec.gov/fast-answers/answerssavingsbondhtm.html