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When cash is king, all other assets are secondary

Cash is always an important asset class. Even when times are good to buy stocks and bonds and other long-term investments, almost all investors have sizable cash balances lying around somewhere. I keep cash in almost all client portfolios, even when they don’t give me explicit instructions to hold a given amount. High-quality cash investments are the ultimate portfolio safety net. Cash gives us not only insurance against declines in other assets, it provides the liquidity cushion that we need.

Conventional financial planning advice says that most households should hold cash equal to about six months of total household expenditures. I think that is a minimum amount, and I generally tend to advise more.

Cash is also the default holding when an investor has not yet decided on a more permanent portfolio. It takes time to put together a comprehensive investment plan, and funds will sit in cash instruments while we’re cobbling together our long-term strategy. Finally, cash is the hiding place for money when we don’t like other choices. If you think that stocks and bonds are too pricey and too risky, your alternative should be cash.

However, cash is perhaps the most mismanaged aspect of most investors’ portfolios. Just because cash isn’t invested in stocks and bonds doesn’t mean you just let it sit in a bank account. With all due respect to my friends at the banks, bank accounts are a bad cash investment. Typical bank account interest rates are several percentage points below what is available elsewhere - or even zero if you’re really asleep at the switch.

Do not confuse all certificates of deposit with cash investments. My rule of thumb is that CDs that mature in six months or less are cash. CDs maturing in six months or more are short-term bonds, not cash. For an investment to count as cash - or a “cash-equivalent” - you need to be able to get your hands on the money with two conditions met: First, you have to be able to get the money quickly, say within a day or three. Second, you have to be able to get the money without taking a sharp reduction in the amount you thought you had. If you have to pay a big penalty to get out of a CD quickly, you fail this second test.

There are a number of simple alternatives to leaving cash sitting in a bank account. The first and perhaps simplest is a money market account. A money market is a mutual fund that invests in short-term bonds and other “near-cash” instruments. The fund offers you a one-day turnaround of your invested cash, and all but guarantees you that you can withdraw as much as you want on a moment’s notice and pay no penalties or withdrawal fees.

For all practical purposes, it is like a checking account.

A quick Internet search tells me that the current national average money market rate is a little under 4.7 percent. Naturally, I don’t like getting the “average” return. It’s my job to shop around.

When I shop around, I usually check Vanguard first. Vanguard is offering up a 5.14 percent return in its flagship money market fund. Most of the popular discount brokerage firms are offering rates just above 5 percent. These accounts are easy to set up, and offer you the ability to link them to your regular bank checking account so that you can make transfers back and forth whenever you want.

Other alternatives to cash include short-term Treasury bills. The 13-week Treasury bill is currently yielding about 4.5 percent. You can buy these from your bank or brokerage firm, but there is a trading fee involved, which will reduce your yield.

For the more aggressive investor, some mutual fund companies offer high-yield funds that behave similar to a money market fund. They pay more in current interest, but subject you to slightly more risk that the daily value of your holdings will fluctuate slightly. An example is the Fidelity Floating Rate High Income Fund (FFRAX). This fund invests most of its money in lower-grade floating rate corporate debt. It has been paying a little over 6 percent, as the share price bounces around between $9.95 and $9.98 per share. This daily fluctuation is what makes this fund different from a money market fund. You might have the bad luck to withdraw money on a day when the value bounces down by a penny or two, which serves to reduce your effective yield.