Understanding Cash

The vast majority of people are mostly or only familiar with money on a cash basis. Your goal is avoiding being one of those people. You still have to understand quite a few things about the most basic monetary vehicle. You obviously need to carry a small amount of cash on you each day. You should not carry too much, since cash cannot be replaced when reported lost or stolen. The rest should be kept in a bank account or cash equivalent instruments until you have built an emergency fund. Then your extra money is constantly saved or placed in your investment accounts.

Cash & Cash Equivalents

Cash is split into two subsections, the first being cash, and the second being cash equivalents. Cash equivalents are ultra-liquid vehicles that have short term durations. They attempt to function almost as fluidly. This means ultra-short term and ultra-liquid instruments: Certificates of Deposit, Checking Accounts, Money Market Mutual Funds, and Savings Accounts. You can withdraw funds from all of these investments except Certificates of Deposits (CDs). CDs have ultra-short maturities which last a few months and offer a fixed security which preserves your cash flow. You shouldn’t rely on the interest rates for certificates of deposit. Short term maturities give a high chance you’ll reinvest at lower interest rates after the Certificate of Deposit matures, depending on central banking rates.

Cash Interest Rates

All cash instruments are savings oriented. They have high liquidity but also carry extremely low interest rates. These rates rarely ever exceed inflation. The interest rate itself is determined by the central bank’s short term interest rate. In the USA this is known as the Federal Funds Rate. When the central bank lowers the short term rate, the yields to cash account rates fall and everyone can acquire capital at cheap borrowing rates. This stimulates economic growth and is usually used to recover from recessions. If the central bank raises the short term rate, cash account yields rise, and everyone acquires capital at more expensive interest rates. This reduces economic growth and is used to slow unwieldy expansion.

Cash & Investing

Why would you use cash equivalents if they’re being beat by almost every other investment’s return? Investments serve your long term goals, but cash is the best for short term needs. The high liquidity allows quick withdrawal in emergencies, making them perfect for emergency funds. Most importantly, you (usually) cannot lose principal from cash based instruments and vehicles. All equities, and even government bonds, can result in principal loss. Cash vehicles are best for capital preservation, maintaining the current level of capital. In exchange, it has virtually no interest rate and your gains are usually lower than inflation.

In recessions, when equity markets crash, alternatives see their investment rates accelerate. Stock pricing is derived from market fluctuations which can often be driven by human fear, greed, rumor, and opinion. The alternative vehicles are commodities, bonds, and savings. These all have fairly stable principal value, and rarely ever fall to absolute zero. “Principal safe” savings vehicles help to avoid losses in rough financial markets. Preservation of principal prevents current losses. The tradeoff is limited earnings potential. If the market recovers and moves upward, you will not gain returns and your overall portfolio return will suffer. This is known as “Cash Drag”.

It’s often wise to keep a portfolio with a certain percentage of cash or savings vehicles. Typically five to ten percent, this is known as your cash reserve. Instead of selling existing investments and triggering capital gains, you can simply purchase new investment opportunities with your cash reserve. You can add money from future paychecks into your cash reserve, restoring the value back to its five percent range. You also won’t suffer from heavy cash drag on your portfolio.