Cash seems like a simple-enough concept — greenbacks, coins, numbers in a bank account. But it’s actually a bit more complicated than that, and when you think about cash, and what kinds of risks you’re willing to take for bigger yields, it pays to break your cash holdings into different categories, especially when yields are as low as they are today.
For most people, cash is saved for one, two or three purposes.
The first, obviously, is spending. That includes the money in your wallet or change purse, as well as immediately accessible, safe holdings like checking, money market and savings accounts. This tangible cash is used for ordinary expenses.
The rule for handling this type of cash is pretty simple these days: forget about yields, as you’ll earn almost nothing. Emphasize safety, with FDIC-insured accounts. Then look for convenience, picking a bank that offers many ATMs in your community, as well as online banking and other services you want.
The second type of cash savings is the rainy-day fund. Again, you need to emphasize safety. Use bank savings that won’t fluctuate in value, so your values won’t be down when you need to tap the fund, as they might be if you put your emergency fund into stocks.
But with a good-sized rainy-day fund, you probably won’t need to get at all of your money at once. If you lost your job, for instance, you would draw part of the fund every month. That means you can afford to tie some of this money up a bit longer to earn more.
A 12-month certificate of deposit, for example, yields 0.622%, compared to 0.28% in a money market account, according to the BankingMyWay survey. If you have tens of thousands of dollars in an emergency fund, these little differences can add up over the years.
In a big emergency, you could redeem the CD early. Although you’d probably lose several months of interest earnings, you might still earn more than you would in a money market. Also, money in a one-year CD will be available fairly soon, so you can reinvest if newer CDs pay more.
The third type of cash is part of a long-term investment portfolio. It is used to diversify, or minimize risk, and it’s kept in reserve for a good investment opportunity. Because you don’t expect to need this cash in the short term, you can consider tying it up in alternatives that aren’t quite cash but are pretty close.
That includes investments like mutual funds containing short-term bonds. Historically, these will offer higher yields than you can find in bank savings, but with more risk. Mutual funds are not FDIC insured, and rising interest rates could drive down the values of bonds in the fund, producing a loss that more than offsets the interest earnings.
Morningstar (Stock Quote: MORN), for example, suggests the Vanguard Short-Term Bond Index Fund (Stock Quote: VBISX), currently yielding 2.28%. The fund has a good track record, and is up about 4.5% this year, counting interest earnings and share-price gains.
But it’s not risk-free. It has a duration of two and a half years, which means share prices could fall by 2.5% if prevailing interest rates rose by 1%. Many of the gains in recent years, for this fund and others like it, came as falling interest rates pushed bond prices up. Now, with rates at rock-bottom, it’s more likely the process will be reversed, with bond prices falling as rates rise.
So even for this third type of cash bank savings aren’t a bad option. You won’t get stellar yields, but you’ll be protected from loss. And you’ll get same stabilizing effect in your portfolio that you would from short-term bonds.
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