by Russ Allen, Online Trading Academy Instructor
Online Trading Academy Article of the Week
The idea that there might be more than one kind of cash seems a bit strange. But it is true, and it could be important to you.
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Every individual investor needs to have a certain minimal amount of ready cash on hand for household expenses and everyday emergencies. Before you can confidently undertake an investment plan, you must make sure that your plan won’t be derailed by, say, having to buy a new refrigerator.
Some people who are very risk-averse enjoy the security of having a larger amount of cash available, rather than risking a drop in value of some other type of investment. Even though from an economic standpoint having a large amount of cash poses large opportunity costs, that is a choice that some people willingly make.
So, we want to keep some amount of money in cash. How do we do it?
One thing I want to get out of the way at the outset is that currency and cash are often used interchangeably, and usually that is fine. However, there now exist digital currencies, and these are emphatically not what I mean here by cash. At this stage of their development, digital currencies’ purchasing power fluctuates so wildly that they are just about the polar opposite of what I mean by cash.
Ways to Keep Money in Cash
The physical stuff: bills and coins
Pros:
- Cash offers the ultimate liquidity. It’s legal tender – that means if you tender it as payment, legally it has to be accepted.
- There is no need for interaction with financial institutions.
- Cash is easy to use for small purchases, or where other payment methods aren’t accepted.
Cons:
- If you’re robbed, your cash is gone. And you are a tempting target.
- Cash is inconvenient for large purchases and it’s bulky.
- You could be suspected of being a drug dealer. This has its own set of inconveniences, as anyone who has attempted to deposit or withdraw more than $10,000 in cash from a U.S. bank recently can verify.
- Seriously speaking, the biggest con is no yield. Cash in the mattress earns nothing.
Demand deposits: checking accounts
Pros:
- Checking accounts are convenient and it is easy to make payments of any size.
- Checking accounts offer the security of being FDIC insured. You are technically lending your money to the bank, but the government guarantees that the bank will repay you.
- Your money is immediately available.
Cons:
- Again, no yield.
Bank Savings Accounts
Pros:
- Bank savings accounts will earn some interest.
- You can deposit and withdraw any amount at any time from a savings account.
- You can get money from the bank as you need it.
Cons:
- Savings accounts offer low yields compared to any other kind of savings vehicle.
Online savings accounts
Pros:
- Online savings accounts often offer better yields than those offered at banks with brick-and-mortar branches due to lower overhead costs.
- Online savings accounts offer equivalent security to checking accounts as long as the online bank is FDIC insured.
- Offers mobile banking and easy transfers between online banks and other institutions.
Cons:
- No personalized service.
- Limited offerings mean that you still need a regular bank for other needs.
Money Market Accounts at FDIC Insured Institutions
Pros:
- Money market accounts offer higher yields than other types of insured instant-access accounts
- They are FDIC insured. (not to be confused with a money market mutual fund or ETF, which is not insured)
- There is availability of funds through ATMs, transfers and checks.
- Interest is compounded frequently.
Cons:
- Higher minimum balances are required in money market accounts. This can range from $1,000 to $25,000 depending on the institution.
- Monthly fees are charged if the balance falls below the minimum.
- There are a limited number of withdrawals and transfers allowed monthly – not to be used as a high-volume checking account.
- Money market rates are not locked in and can fluctuate over time.
Bank Certificates of Deposit
Pros:
- Certificates of Deposit are FDIC insured.
- CDs offer higher yields than any instant-access account. Yields are (generally) higher the longer the original time to maturity is.
- Maturities offered range from three months to ten years.
- Yields are locked in until the maturity date. This is good in times when interest rates drop.
- CDs with staggered maturity dates can be arranged in a CD Ladder, combining the advantages of short-term and long-term CDs.
Cons:
- CDs offer limited liquidity. If money is withdrawn before the CD’s maturity date, you can forfeit all interest income.
- Yields are locked in until the maturity date. This is bad in times when interest rates rise.
- There is inflation risk with CDs. CD yields tend to go up more slowly than inflation and drop quicker.
Brokered Certificates of Deposit (purchased through stockbrokers)
Pros:
- Brokered CDs are FDIC insured.
- Brokered CDs offer higher yields than bank CDs.
- Some Brokered CDs allow early redemption if an owner or co-owner dies.
- Higher-yielding ladders can be constructed using Brokered CDs.
Cons:
- Brokered CDs offer the highest minimum deposits – often $25,000 to $100,000.
- Some brokered CDs are callable – they can be redeemed early by the issuer.
- There are higher penalties for early withdrawal of Brokered CDs.
Money Market Mutual Funds and Money Market Exchange-traded Funds
Pros:
- Some money market mutual funds and ETFs have higher yields than bank money market accounts.
- Their rates float with prevailing short-term interest rates. (good in rising rate environments)
- There are no minimums balances and they offer immediate liquidity by selling shares.
- They are convenient within the umbrella of your equity brokerage account – offer easy transfer between cash and other investments.
Cons:
- Money market mutual funds and ETFs are not FDIC insured. However, there is low but non-zero probability of principal loss.
- The rates float with prevailing short-term interest rates. (bad in falling rate environments)
As you can see from this list, there are several different alternatives for your cash balances. The general rule is that the longer you commit, and the less liquidity you require, the more you can earn on your cash. If the amount of cash you have is substantial, it is worth your while to investigate these different vehicles.
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