What is cash, and why is it important?
The word “cash” tends to evoke images of dollar bills or paper currency. You might ask a friend if they have cash to pay the hotdog vendor at a ballgame, for instance. But zoom out from those daily interactions, and cash takes on a much broader meaning.
Often, cash is synonymous with liquidity. You can tap into its value quickly—simply go to the bank and withdraw what you need. This accessibility can translate to opportunity. If you get the chance to purchase a property, for example, having cash on hand for the down payment allows you to seize that opportunity without pausing to unwind other investments.
Often, that opportunity comes with a tradeoff. While bank accounts do pay interest on cash deposits, the rate tends to be significantly lower than less liquid accounts and products. These lower rates are a primary reason financial advisors and money managers tend to recommend cash equivalents.
What are cash equivalents?
Cash equivalents are short-duration products designed to be highly liquid (like cash) while providing a higher return than a standard checking or savings account.
Cash equivalents include short-term certificates of deposit (CDs), money market funds, Treasury Bills (T-Bills or Bills), and commercial paper. Some of these products are insured by the Federal Deposit Insurance Corporation (FDIC) up to a certain amount.
For instance, CDs issued by an FDIC-insured bank are FDIC insured up to $250,000. (The FDIC insures up to $250,000 per client at a given institution, so if you have other accounts at the bank, those will also count toward the $250,000.) Similarly, many FDIC-insured banks offer money market savings accounts.
However, you can also invest in money market mutual funds, which are regarded as investment products and may not be FDIC insured. Similarly, T-Bills and commercial paper are investments that function like short-term bonds. Durations range from one month to nine months (commercial paper) or a year (T-Bills).
T-Bills and commercial paper function differently than traditional fixed income investments. While a bond is issued at face value (par) with a specific interest (or coupon) rate, cash equivalent investments are simply sold at a discount to face value; there is no coupon rate to consider. When the Bill or paper reaches maturity, the buyer is paid face value, unless the issuer defaults. As with bonds, the risk associated with these products depends on the creditworthiness of the issuer, and higher-risk products tend to pay higher yield.
At Quorum, we may use cash equivalents when managing the cash allocation in client portfolios. Which products we choose depends on individual client needs. The goal is to balance the return on these products with the risk involved and the need for liquidity.
How does cash fit into a financial plan?
Everyone’s financial plan is different; it's based on your current needs and future goals. The role cash plays may vary accordingly.
To determine an appropriate cash allocation, we look at your emergency savings and upcoming expenses. When selecting products, we keep these criteria in mind while also evaluating the overall economy and market rates for cash equivalent products.
In the long run, cash is less attractive as an investment since it loses purchasing power over time due to inflation. This is even more true when inflation is high, as it has been since 2021. However, as the Federal Reserve raised rates to combat inflation, the situation evolved.
The Fed’s multiple rate hikes starting in 2022 caused most short-term debt to pay a higher interest than long-term debt. (You may hear this referred to as an ‘inverted yield curve.') In a normal economy, short-term bonds pay less interest than long-term bonds; all-else equal, shorter-duration products tend to carry less risk.
When the yield curve inverts, these short-term products, like cash equivalents, become more appealing—they pay a higher yield while carrying less inherent risk. Plus, higher yields on cash equivalents may help counteract the effects of inflation on a cash allocation.
For these reasons, the team at Quorum regularly reviews cash allocations with clients as part of a diversified portfolio. Our goal is to leverage potential opportunities while staying true to each client’s risk tolerance and overall goals. If you have questions about the cash allocation in your portfolio, reach out.
