By: BankingMyWay.com Staff
When someone writes you a check, even before you deposit it into your bank account the check is as good as cash. That’s because you know that you have access to the money even if you are not holding it in actual currency. If you wanted, you could sign the check over to someone else as a payment, just like paying with cash. Gift certificates and gift cards operate in the same way. All of these instruments are cash equivalents.
In the investing world the terms “cash” and “cash equivalents” are often used refer to safe, liquid investments where the returns are practically guaranteed. With these properties, they offer virtually the same benefits as holding cash and can be easily converted into cash if the need arises.
There are a number of investments that qualify as cash equivalents including:
• Treasury Bills (T-Bills)
• Short-Term Government Bonds
• Marketable Securities (commercial paper, banker’s acceptances)
• Money Market Funds
• Money Market Accounts
• Short-Term Certificates of Deposit (CDs) (with maturity dates under 3-months)
The safety of cash equivalent investments is paid for by low interest rates. While they offer a guaranteed return of principle and modest interest, those returns typically barely keep up with inflation. In today’s market, however, even the super low interest rates of cash equivalent investments are outpacing inflation, which is currently negative. According to BankingMyWay.com, the current national average interest rate for a money market account is 0.497%. For a three-month CD, it’s 0.695%. Using the Consumer Price Index published by the U.S. Bureau of Labor Statistics (BLS), inflation is calculated at -0.7% for April 2009. Typically, annual inflation rates hover between 2% and 4%, however.
Because of the virtually guaranteed return, cash equivalent investments can often be used as collateral for loans very easily. For instance, business owners often borrow against the receivable balances of outstanding accounts, and lenders use payments made on the invoices to pay off the loan.
Since the stock market downturn, many investors have rushed to cash equivalent investments to protect their principals. The high demand for Treasuries has actually had an increasingly negative impact on yield. In the quest for safety, however, many investors are sacrificing the potential for long-term returns.
Now is the best time for the long-term investor to get into the market. Stocks are bargain-priced, so investors can get more bang for their buck. If or when the market rebounds in the long-term, those who bought during the bear market will likely see significant returns. By the same turn, if/when inflation returns, those who are too heavily invested in cash equivalents may find most or all of their returns eroded by rising prices.
The best use for cash equivalent investments is for emergency fund holdings and temporary places to park cash between investments. These types of investments offer peace of mind in the short-term and easy access to funds, but the opportunity cost of keeping too much cash in your portfolio over the long-term can be expensive.
From Banking My Way