Cash: What It is and How to Use It

This past weekend the Wall Street Journal carried a somewhat confused article on what we hip investor types call cash. Just to be clear, what we refer to is not literally cash, not slips of paper with pictures of dead politicians, but rather highly liquid assets we can use to buy stuff. Like a checking account.

I say the article is confused (and confusing, for that matter) because although it starts with important reminders about how chasing slightly higher yields on cash caused many investors great pain in the fall of ‘08, and then repeats the equally important principle that “the only way to boost yield is to take more risk” it promptly explains how to boost yield by taking more risk with your cash.

Generally speaking, the interest rate you get paid on cash deposits, in money market funds, short term Treasuries, and the like, is very low. It usually approximates the inflation rate, meaning that with a little luck the real value of your cash treads water.

Recently, rates have been about as close to zero as is physically possible. Bank of America just sent me some spam offering a checking account that pays 0.05% for deposits less than $10,000. Were I to let them hold more than ten large the rate would double to 0.10%. Woo-hoo.

Compared to inflation, which ran at an annualized rate of 0.84% in the six months to February, that is not so bad. But in absolute terms, and compared to what we have grown to expect and think is normal, it is alarmingly, perhaps even outrageously, low. So it is natural to want to take action to fix the problem, to find ways to increase the yield you get on cash by going into better paying cash-like investments.

Don’t do it.

Cash is not an investment. It is a place for the temporary storage of value. Getting a little something in the form of interest is nice, but in the big picture it is trivially irrelevant. Even when rates on cash are on the high side they are only a few percent on what ought to be a thin slice of your total wealth.

If it is more than a thin slice then you are probably doing something wrong. (An exception being if you are in full bunker mode, expecting a large scale meltdown in all investments similar to what happened in 2008. But you wouldn’t be particularly concerned about yield then either.)

Cash should not be confused with low risk or risk-free investments. Cash does have that characteristic, but it is also very liquid, meaning you can spend it at a moment’s notice. You might need that kind of liquidity for some of your wealth, for example for an emergency fund, but that is not an investment and you shouldn’t be trying to make money on it.

On the other hand, you might reasonably desire to put a chunk of your assets in something low risk or even no-risk. For that you should consider fixed income, i.e. bonds, particularly Treasuries, which have the risk characteristics of cash without the liquidity. You get a lot of additional yield for giving up liquidity. Although Treasuries maturing in the next few months pay less than 0.25%, the ones lasting two years will get you more than 1%, and five years will get you about 2.75%.

Personally, I generally have no cash. I have a small pile just now, because I need to write checks later on this week to the IRS and its Massachusetts equivalent.

And I will be taking Bank of America up on its offer. They promise to pay me a $100 bonus if I open an account with $250 and keep it there for 30 days. That’s a 5569% annualized return on my money. Even I am willing to chase that yield on my cash.

Investing, Media | Frank Curmudgeon | April 12, 2010 11:59 am

17 Comments

By Neil, April 12, 2010 @ 12:18 pm

Question – many people lack the skills or inclination to properly vet risky investments. Would it not make sense for this group of people to chase higher interest on cash in the form of FDIC insured savings accounts, which some online banks are offering in the 2% range while maintaining liquidity?
By Investor Junkie, April 12, 2010 @ 11:34 pm

I’m confused with this post more than the original post. You mention cash yourself, yet are talking about investing. If you need it in the short term (say less than 30 days) it shouldn’t be invested in anything. it should be sitting in your bank account. Maybe your savings account.

The WSJ article didn’t mention time frame, but I believe hey were referring to short-medium term (ie less than 5 years) as a comparison. Even that far out on the yield curve is rather awful.

Is it safe to say with any of the financial instruments mentioned it’s either loss of principle risk or inflation risk. The question to Frank aren’t they really the same thing, loss of your dollar purchasing power? The question is which is the lesser of the two evils. Right now it’s inflation risk, but couldn’t that change quickly only one year?
By Rob Bennett, April 13, 2010 @ 5:31 am

Cash is not an investment. It is a place for the temporary storage of value.

We disagree, Frank. Cash is a strategic asset class. It’s a mistake to look only at the nominal interest being paid on cash. You also need to consider the gains you obtain by investing in cash at times when stocks are insanely overvalued. Doing that leaves you with more money to invest in stocks after stock prices crash. So you need to count the gains obtained from the stocks you end up buying as part of the total return obtained by investing in cash at the earlier time.

Cash was set to pay a higher long-term return than stocks for the entire time-period from 1996 through 2008.

Rob
By Tom, April 13, 2010 @ 1:52 pm

I have a high-interest checking account that pays 4.01% on up to $25,000. I make about $60 a month by keeping all my cash there; no downside that I can see.
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