This is part of a new series on Investments. Focus on Investments will explore investments basics in a simple and easy to understand manner. This week we talk about Cash and Cash Alternatives.
When I first learned that cash and cash alternatives were a class of investment, all I could say was who knew? I always thought that cash was, well, er, cash!
And the term cash alternative was absolutely foreign to me. What could be an alternative to cash? -Don’t even think about saying credit card!!
Cash
I was right about cash. It is the currency, coins, checks and money orders that we see all around us in our daily lives. However, you can invest in cash. When you do, you are investing in a cash alternative or cash equivalent.
What are Cash Alternatives/Cash Equivalents
Cash alternatives are investments that are considered relatively low-risk (notice I did not say risk free). They are lower risk than bonds. And, cash alternatives are considered highly liquid because they can generally be converted into cash quickly. Some of the most common examples of cash alternatives include:
- Savings accounts
- Money market deposit accounts
- Money market funds
- Certificates of deposit (CDs)
- U.S. Treasury bills
The Advantages and Uses of Cash Alternatives and Cash Equivalents
Because of their conservative nature, cash alternatives involve the least risk.
And, cash alternatives can be useful to an investor in many ways including:
- To provide relative stability. While cash alternatives can’t assure you of a gain or protect you from losses, they are generally considered safer than other types of investments such as stocks or bonds.
- To earn income on cash that would otherwise be idle. Most cash alternatives pay interest, which may help to reduce the effects of inflation.
- To maintain a ready source of cash to pay for goods or services, such as a down payment on a home or car, a new washing machine, or a family vacation.
- To meet unexpected demands on cash, such as repairing storm damage to your home or other financial emergencies.
- To serve as a temporary parking place for assets when you’re not sure where to put your money.
The Disadvantages and ‘Gotchas’ of Cash Alternatives
There is a tradeoff for the relative safety of cash alternatives. All investments have risk.
Opportunity cost
The primary tradeoff you accept in return for the relative safety of cash alternatives is that their potential return is not as high as higher-risk investments (this is known as opportunity cost). By playing it safe, you may be limiting your investment income, especially over longer time periods.
Risks
No investment is completely without risk, and different types of cash alternatives carry different levels of risk. Here are some risks to keep in mind:
- Because returns on all types of cash alternatives are relatively modest, earnings may not keep pace with inflation, especially over longer periods.
- While checking accounts, savings accounts, and bank CDs are FDIC insured (up to a limit), other types of cash alternatives are not. For example, the principal value of U.S. Treasury bills will fluctuate with market conditions, and may be higher or lower if you choose to sell before maturity.
- While government savings bonds, U.S. Treasury bills, and U.S. government securities are backed by the full faith and credit of the United States, other cash alternatives carry higher default risk.
- Even if a mutual fund invests in cash alternatives backed by the full faith and credit of the United States, the fund’s shares are not guaranteed or insured by the FDIC or any government agency. Though a money market fund attempts to preserve the value of your investment at $1 per share, it is possible to lose money investing in one.
As an investor, you get paid for taking risk. -Less risky investments generally do pay less. Riskier investments generally do pay more. Nothing is absolutely safe. If you keep you money in cash, over the long term inflation will make you poor. If you invest, you are subject to risk. There are no guarantees in the investment world. But, cash and cash alternatives a generally good places to keep money that you will need in the near future.
This information is for general financial education purposes only and is not a recommendation for buying or selling cash alternatives. Consult your financial advisor before buying or selling cash alternatives or cash alternative products.
Jane Nowak, Financial Planner and MoneyGal2020 is a Financial Planning and Retirement Specialist for Women. She works at Kring Financial Management in Atlanta, GA http://www.kringfinancial.com/JNowak.htm Follow her on Twitter at: MoneyGal2020 and on WordPress: http://moneygal2020.wordpress.com/
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Andrea is the Chief Chick of Smart Money Chicks. After filing BK twice (once because she panicked, second time because the pro messed the first time up), she realized that it all could have been avoided if she understood more about how her Finances worked and the options available. At that point, she wanted to help as many as she could never make the same mistakes again. Our Promise is that all the content you read on here is created or edited by Andrea
Good info it jogged my memory of basics I learned in college 45 years ago.
Thanks! I hope to read more of learn to invest.