Holding Cash
Nearly every investor holds a certain amount of cash. That's because cash can play a
vital role in meeting a short-term savings goal or play a larger part in a long-term asset portfolio.
Whether it's to meet a short-term or longer-term need, there is always a good reason for holding
cash.
In this publication, we're going to discuss some of the more practical, as well as strategic, reasons
for holding cash in a portfolio. Next, we'll talk briefly about the performance of cash investments
over time. Finally, we'll finish up with an outline of the various cash funds you can own as part
of your investment portfolio.
Reasons for Holding Cash Additional Resources
Investing Money
Perhaps the best explanation for holding cash in a Cash Investments
portfolio was summarized by John Maynard Keynes, after Holding Cash
which Keynesian economics or Keynesian Theory is Inflation and Deflation
named. Keynesian economic theory states that both the FDIC Insurance Coverage
state (government) and private sectors play an important Investing Online
role in the health of an economy. In particular, Keynes
also spoke about the importance of cash.
Three Motives for Holding Cash
In his publication on The General Theory of Employment, Interest, & Money, Keynes outlined
three reasons, or motives, for holding money or cash:
Transaction Motive - cash is held to pay for goods or services. It is useful for
conducting our everyday transactions or purchases.
Precautionary Motive - cash is a relatively safe investment. Cash investments rarely
lose value (as can stocks or bonds) and are therefore held for safety reasons in a balanced
portfolio.
Asset or Speculative Motive - cash investments provide a return to their holders.
There can be many variations on the reasons mentioned above, but these three reasons are
perhaps the best overall explanation as to why cash plays an important role in any investor's
portfolio.
At a very practical level, we own cash investments to pay for our daily or monthly expenses. At a
more strategic level, cash provides an investor with a way to control risk as well as gain a return
on their investment.
Performance of Cash Investments
We just mentioned that one of the three motives for holding cash was safety. If we believe that to
be true, then the lower risk associated with cash should be "rewarded" with lower returns to the
investor. The table below illustrates that point.
In this table we are showing the 5, 10, and 15 year annual return for equities (stocks), bond funds,
stable value funds, money market funds as well as inflation. The period of time over which these
returns were measured is ending September 2006.
Relative Performance of Cash Investments
5 Year 10 Year 15 Year
Equity Funds 5.12% 6.87% 8.59%
Bond Funds 4.33% 5.59% 6.30%
Money Market Funds 2.22% 3.68% 3.91%
Inflation 2.62% 2.82% 2.65%
Source: Bloomberg Information and the U.S. Department of Labor Inflation Calculator
The equity fund returns were based on the S&P 500 Index, while the bond fund returns were
based on the Lehman Intermediate Government Credit Index. Money market funds typically
invest in high-yielding, short-term money market instruments such as U.S. Treasury bills, bank
certificates of deposit, and commercial paper. In this example, money market returns were based
on the Lehman U.S. Treasury Bellwether Three Month Index.
As the table above indicates, money market funds have been outpaced by inflation over a five
year period, and have provided investors with only a modest return of 1.26% in excess of
inflation over this 15 year period of time. We can also see from this table that investors willing to
accept progressively higher risks have been rewarded with progressively higher returns.
When Cash is King
Perhaps the most advantageous time to hold cash is when a recession hits, and the economy starts
to slow down. When that happens, you'll be glad you were holding cash if you lose your job. If
the stock market takes a dive, you'll be glad you had some spare cash to buy stocks at bargain
prices.
When a recession occurs, cash will allow you to get a great deal on everything from cars to
homes, as dealerships and builders lower prices to sell off excess inventory. This is just another
reason that holding cash is so important to every investor.
Six Ways to Hold Cash
Despite the fact investors can obtain much higher long-term results owning other investments,
cash is important to everyone. That's because one of the three reasons for holding cash includes
the transaction motive. Most everyone needs cash to pay for expenses such as monthly credit
card bills or even a cup of coffee.
Generally, there are six ways for investors to hold cash including:
Savings Accounts
Money Market Accounts
Money Market Funds
Treasury Bills
Certificates of Deposit
Ultra-Short Bond Funds
We're going to finish this article by describing each of these methods in more detail in the
sections below:
Savings Accounts
Savings accounts typically offered by banks provide investors with arguably the lowest return or
yield. With these types of accounts, you have immediate access to your money and the Federal
Deposit Insurance Corporation insures your money against loss. The basic insurance amount is
$250,000 per depositor, per insured bank.
Money Market Accounts
A second type of cash account offered by banks is a money market account. Once again, this
type of account is FDIC insured, and will pay returns that are comparable to money market
funds. Withdrawals and deposits (in-person) are allowed, however, if check writing or third party
payments are offered, then the number of transactions each month will be limited.
Money Market Funds
A money market fund is a mutual fund that is required to invest in low-risk securities such as
those issued by the U.S. government, financially-stable corporations with high bond ratings, as
well as bonds issued by state and local governments. These funds have relatively low risks
compared to other mutual funds, and usually pay dividends. Money market funds are not
federally insured.
Treasury Bills
Treasury bills are debt obligations of the U.S. government. A Treasury bill, or T Bill, is a short-
term investment issued for a year or less. Treasury bills are backed by the U.S. government's full
faith and credit.
The U.S. Treasury issues bills with the following maturities and frequency:
3-week bills and 26-week bills are auctioned once a week
4-week bills are auctioned once a week
Cash management bills (CMBs) are used to help the government meet its short-term
borrowing needs (term is usually very short: days)
Treasury bills can be purchased either directly from the Treasury or through an investment
professional such as a bank or broker.
Certificates of Deposit
A certificate of deposit, or CD, is a time deposit with a bank, credit union, or thrift institution.
CDs are similar to the concept of savings accounts mentioned earlier in that they are insured by
the FDIC. Certificate of deposits are offered in fixed terms that span from as short as three
months to as long as five years.
A CD is meant to be held until maturity, and the rate of interest is usually fixed. Compounding of
interest can vary. In exchange for allowing the financial institution to hold the money for a fixed
period, these same institutions reward the depositor with interest rates that are higher than those
of savings accounts.
Ultra-Short Bond Funds
An ultra-short bond fund is a mutual fund that invests in fixed income securities that have
relatively short maturity timeframes. Just like other mutual funds that invest exclusively in
bonds, the ultra-short funds often invest in a wide range of securities. For example, the fund
might own corporate bonds, government securities, and even mortgage backed bonds.
Since ultra-short bond funds are permitted to invest in a wide range of investments, the yield on
these funds is typically greater than a money market fund, which is limited to higher quality
investments as described earlier. Just like other mutual funds, this money is not insured by the
FDIC.
