Investing 101: 3 Things You Should Know about Cash and Cash Equivalents

Investing In Cash?

This is our fifth post in our Investing 101 Series. See the whole list here. 51 percent of Americans didn’t invest for retirement in 2014. Their reason for not investing? They didn’t know enough about investing to invest. We hope to help fix that with this series.

So far, we’ve discussed investing in stocks, mutual funds, Exchange Traded Funds (ETFs) and bonds. In this, our last week, we’ll discuss investing in cash and cash equivalents.

1. What are Cash and Cash Equivalents?

Cash is the cold, hard green paper we stuff in our wallets.

Cash equivalents are extremely short-term investments that are easily converted into cash, highly unlikely to lose value and are high credit quality. They are, however, not guaranteed to not lose value.

2. What Types of Cash Equivalents Are There?

When we discussed investing in government bonds last week, we discussed Treasury bills that mature in three months or less. Investments that mature in less than three months are cash equivalents. Therefore, Treasury bills are considered cash equivalents. Investments that mature in longer than three months aren’t considered cash equivalents.

Other fixed income investments that are considered cash equivalents include bank certificate of deposits (CDs), bankers’ acceptances, savings accounts and commercial paper, all of which are short-term investments in that they mature within three months or less.

Money Market Mutual Funds are cash equivalents. These are mutual funds that consist of only the short-term investments previously mentioned. Even though they are a basket of short-term investments, they’re considered liquid. One can pull cash out of a money market within 24 hours.

Preferred stocks purchased close to their redemption dates are considered cash equivalents.

3. What Are the Rewards and Risks of Owning Cash Equivalents?

The reward of investing in cash and cash equivalents is that they are stable and liquid. Money market investments don’t quickly appreciate and depreciate in value. It’s, also, easy to get your hands on the cash invested in them, if needed.

For example, if you know you need to put 20 percent cash down on a house within the next three months, you won’t want to put that cash in the stock market. For numerous reasons, your 20 percent downpayment may not be there in three months. For such a short period of time, it makes sense to put that money in a more stable, short-term investment. There’s a 99 percent chance your 20 percent downpayment will be there and you’ll, at least, earn some interest on the investment.

The risk is that because these investments are low risk, they have no chance of increasing significantly in value. This stability, however, means the money held in these investments, as well as cash, often lose value over time because of inflation. We mentioned inflation risk last week. The same risk applies to cash and cash equivalents.

For example, if your entire investment portfolio is worth $10,000 and you won’t retire for 40 years, it doesn’t make sense to put that $10,000 in cash or cash equivalent investments. You won’t have much more than $11,000 when its time to retire.

When considering your investing overall portfolio, however, it makes sense to have a portion of it in cash or cash equivalents to provide some stability overall. Of course, a healthy and appropriate mix of all the investments we discussed makes the most sense for most investors.

That’s what you need to know about cash and cash equivalents. With this basic understanding now of stocks, mutual funds, ETFs and bonds, you have a greater knowledge of investment types than most Americans.

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