- Last Updated: Monday, 26 October 2020
Nearly every investor holds cash. That's because it can play a vital role in meeting a short-term savings goal or play a larger part in a long-term asset portfolio.
In this article, 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 funds an investor can own as part of their overall portfolio.
Reasons for Holding Cash
Perhaps the best explanation for holding cash in a portfolio was summarized by John Maynard Keynes, after which Keynesian economics or Keynesian Theory is named. Keynesian economic theory states that both the state (government) and private sectors play an important role in the health of an economy. In particular, Keynes also spoke about the importance of cash.
Motives for Holding Money
In his publication on The General Theory of Employment, Interest, & Money, Keynes outlined three reasons, or motives, for holding money or cash:
- Transaction Motive: to pay for goods or services. It is useful for conducting everyday transactions or purchases.
- Precautionary Motive: it's 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: it can 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, it provides an investor with a way to control risk as well as gain a return on their investment.
Return on Investment
We just mentioned that one of the three motives for holding cash was safety. If we believe that to be true, the lower risk should be "rewarded" with lower returns to the investor. The table below illustrates that point.
In this table we are showing the 3, 5, and 10 year annual return for equities (stocks), bond funds, money market funds as well as inflation. The period of time over which these returns were measured is ending September 2020.
Relative Performance of Cash Investments
Source: BoomBarc US 5-10 Year Corp Index, S&P 500, Money Market Funds Average, 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 information obtained from BoonBarc US 5-10 Year Corp Index. Money market funds typically invest in high-yield, 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 Vanguard Prime Money Market Fund.
As the table above indicates, money market funds have been outpaced by inflation over a ten year period. We can also see from this table that investors willing to accept progressively higher risks have been rewarded with progressively higher returns.
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, cash investments can help fill income gaps if a job is lost. If the stock market takes a dive, cash can be used to buy stocks at bargain prices.
When a recession occurs, it allows individuals to get a great deal on everything from cars to homes, as dealerships and builders lower prices to sell off excess inventory.
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 it includes the transaction motive. Everyone needs cash to pay for expenses such as monthly credit card bills or even a cup of coffee.
Investors looking to improve their cash holdings have roughly six options, 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 approaches in more detail in the sections below:
Savings accounts typically offered by banks provide investors with the lowest return or yield. With these types of accounts, there is immediate access to money and the Federal Deposit Insurance Corporation insures against loss in the event the bank fails. 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 are debt obligations of the U.S. government. A Treasury Bill, or T Bill, is a short-term investment issued for one 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 securities, 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.
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