Although long-term historical analysis clearly shows that the equity markets have historically risen about two-thirds of the time over the decades, there are always going to be periods where the markets experience substantial volatility. Of course, this usually triggers a flight to safety by investors who funnel their funds into cash instruments such as short term certificates of deposit (CDs), money market funds and Treasury securities. Cash can really be king when the stock and bond markets become chaotic. (For more, see: Getting to Know the Money Market.)
Safety and Stability
Although the rates that they pay are low compared to equities or longer-term fixed instruments, cash instruments offer some obvious advantages. In many cases, their principal and interest is guaranteed by the issuing authority, or else the portfolios that they invest in, such as money market instruments are so stable that they are generally considered to be safe havens even during periods of extreme market instability. Cash is also by far the most liquid type of asset class, as no real buy or sell transaction is usually necessary to access it. Even those who trade in and out of the markets during periods of high volatility use cash accounts to land in when they are not holding other positions. When the markets get too rough, some of the common cash instruments that investors choose to land on include: (For more, see: Get a Short-Term Advantage in the Money Market.)
- Money market mutual funds – These funds invest in short-term debt obligations with maturities of 270 days or less and are available at just about any bank or investment company. All mutual fund companies also have at least one money market fund in their family, and some offer municipal money market funds that pay tax-free interest to those who live within that fund’s jurisdiction. Money market funds offered by banks are also typically accorded Federal Deposit Insurance Corporation (FDIC) protection to provide an additional measure of security. Most of them also have all of the conveniences that you can get from checking and savings accounts, such as check writing, debit cards, ATM withdrawals and automatic bill payment. (For more, see: Introduction to Money Market Mutual Funds.)
- Treasury securities – T-Bills have the shortest maturity of any type of government security. Their maximum term is just one year, and there are also offerings that mature in three, six or nine months. These securities are one of the safest cash offerings available as they are directly backed by the full faith and credit of the U.S. government. The interest that they pay is also exempt from taxation at both the state and local levels.
- Short-term CDs – These instruments are backed by the FDIC and can offer a more varied maturity schedule than T-Bills. They also pay relatively low rates of interest, but investors won’t have to worry about whether their money will still be there next week or month either. Of course, they will have to pay a penalty for early withdrawal. (For more, see: How to Create a Laddered CD Portfolio.)
- High-yield checking accounts – Many banks are starting to merge checking accounts with money market funds in order to pay customers a better rate of interest. Although most money market funds now offer full banking services as mentioned previously, this new type of hybrid account is becoming increasingly common.
- Inflation-Linked Savings Bonds – This can be a good choice for those who want to stay in cash for at least a year. These bonds are indexed for inflation twice a year and can be purchased in denominations as small as $50. (For more, see: Hedge Your Bets With Inflation-Linked Bonds and Introduction to Treasury Inflation-Protected Securities (TIPS).)
- Guaranteed fixed accounts – This type of account is usually available within variable annuity contracts, and the money that is placed into it may not be available for withdrawal without tax and penalty. But these accounts often pay a fixed rate that is higher than what you can get in a fixed annuity or any other type of cash instrument-including the money market fund that is offered inside the contract. Variable contract holders who wish to move to the sidelines until they decide which funds they want to choose next are often wise to use this option.
The liquidity that comes with cash can also help day traders and short-term investors to jump back into the market when they feel that the bottom has arrived. Steep plunges in stock and index prices are often followed by quick rebounds, and those who are able to get in at the right time can make quick profits. But this is only possible when cash is stored in liquid vehicles like checking, savings and money market accounts that allow for instant withdrawals. (For more, see: Understanding Financial Liquidity.)
The Bottom Line
Although cash instruments and vehicles will never compete with the rates of return posted by equities or long-term fixed income instruments, they do offer a measure of safety and stability that cannot be matched by other asset classes. In fact, most financial planners and portfolio managers recommend that investors always keep at least a small percentage of their portfolios in cash in order for this reason. (For more, see: Your Portfolio: Time to Cash In?)