From HSBC United States
Cash equivalents, or cash investments, are short-term investments on which you earn interest. The interest is calculated as a percentage of your principal, as it is with bonds, and may becompound or simple, depending on the type of investment you make.
Types of cash investments
The four major types of cash investments are:
- Certificates of deposit (CDs), which are federally insured bank products.
- US Treasury bills (also known as T-bills), which are backed by the full faith and credit of the US government.
- Bank money market accounts, which are federally insured.
- Money market mutual funds, which are not federally insured but seek to maintain their value at $1 per share.
Liquid assets
One key characteristic of cash investments is their liquidity, which means they can be converted to cash quickly and easily with little or no loss of value. For example, if you put $1,500 into a money market account, you can easily and quickly withdraw that amount of cash if you need it. In contrast, if you were to invest $1,500 in a stock mutual fund, you might be able to sell your shares for more than that amount — but you might also have to sell for less if you needed the money at a time when the fund shares had lost value.
Additionally, because cash investments don't fluctuate in price, you can be comfortable using them as part of your emergency fund to cover unexpected expenses.
Lower rates
In general, though, the interest rates you earn on these investments is several percentage points lower than what you could earn on different investment classes. While many people should have some amount of cash investments in their portfolios, money you hold in these investments is likely to lose buying power over the long term as a result of inflation.
For example, if your five-year CD is paying 3% interest while inflation is averaging 2%, your real return is just 1% before income taxes.
One approach is to use cash equivalent investments as you would savings accounts — to hold money you expect to use in the near future — and to invest for long-term goals with assets that have a greater potential to increase in value.