What About Cash?

At times, depending on what's going on with the markets, the economy and interest rates, you might hear some financial gurus warn, "Cash is trash!" Other times, these market mavens might proclaim, "Cash is king!" In fact, it's not unusual to hear both points of view at the same time.

So, is cash royalty or refuse—or neither? As usual, the answer depends on your situation and financial goals.

What is cash?

In an investment context, cash usually means cash equivalents such as money market funds, Treasury bills (T-bills), short-term corporate commercial paper and overnight government repurchase agreements. There are also shorter-term investment alternatives such as short-term certificates of deposit (CDs), ultrashort bond funds and stable value funds, which are often found in 401(k) plans.

Why hold cash?

Let's look at three broad reasons for maintaining a cash position as part of your financial plan.

Reason No. 1: liquidity

Apart from day-to-day expenses, which you typically pay from current cash flow, the need for liquidity generally falls into two categories:

• Emergencies (health problems, you lose your job, etc.).
• Known obligations coming due in the next one to three years.

For emergency funds, we recommend setting aside cash equal to three to six months of after-tax income. The amount that's right for you depends on your job outlook and other sources of income and credit.

Once you decide how much to set aside for emergencies, including that cash in your portfolio allocation is up to you. Your emergency cash reserve may be larger than your portfolio's targeted cash allocation, in which case you'll need to keep at least some cash outside your investment portfolio. On the other hand, if your portfolio is big enough, you could choose to include your emergency reserve within your targeted cash allocation. Either way, the key is safety and liquidity in case of emergency.

Unlike your emergency reserve, which you maintain "just in case," think about cash that is set aside to cover known obligations as money that's already spent. Known obligations that you might pay from cash reserves (instead of current salary or other monthly income) can include quarterly estimated income taxes, property taxes, a down payment on a home, your child's wedding, college bills, a vacation and so on.

Liquidity is extremely important here—don't invest money reserved for short-term obligations in the market. Instead, keep it in cash, near—cash, or shorter-term investments.

Liquidity for retirees

Retirees typically have special liquidity needs. For example, the need for emergency funds may go away—if you're no longer working, there's no need to plan for the possibility of losing your job. However, you may want to set aside enough cash to cover at least 12 months' living expenses. Think of it as a "known obligation."

Beyond that, it's not a bad idea to keep another two to four years' worth of expenses in shorter-term investment alternatives (short-term bonds, ultrashort bond funds, CDs and so forth) as part of the fixed income portion of your retirement portfolio. That way, when a bear market comes along, you could avoid having to liquidate other assets during the worst possible time, assuming the bear market doesn't last more than a few years.

Reason No. 2: flexibility

By holding a percentage of your portfolio in cash, you can take advantage of investment opportunities as they arise. For example, a cash allocation may come in handy if you wish to slightly overweight or underweight certain asset classes in your portfolio based on your outlook for the markets.

We're not talking about market timing or even large, tactical shifts between stocks, bonds and cash. The odds against being consistently right are too great to make such a huge bet. However, by shifting your asset allocation 5% to 10% one way or the other, you may be able to add value when you're right—without derailing your long—term goals if you're wrong.

In addition, a cash allocation can provide flexibility when it's time to rebalance your portfolio and/or pay investment fees.

Reason No. 3: stability

Bonds have been the traditional choice for reducing a portfolio's overall risk. Bonds tend to perform differently than stocks in the same market conditions—sometimes moving in the opposite direction.

Historically, however, cash is even less correlated with stocks. What's more, cash is far less volatile than bonds on average. The big advantage of bonds, of course, is the potential for higher income. That said, in the appropriate proportion, cash can stabilize your portfolio over time.

Where should you keep your cash?

Whatever your reasons for holding cash, you need a good place to park it. That does NOT include under the mattress or in a big safe. Physical cash earns no interest and can be stolen or destroyed.

The table below summarizes various ways to invest your cash. The information is generally true but it may differ depending on the asset levels and the issuing institution.

Consider these smart ways to invest your cash

Investment	Liquidity	Value	Credit quality
Checking and savings accounts	Immediate	Stable	FDIC insured
Money market funds	Immediate (may be limits on writing checks)	Stable	Not FDIC insured
Position-traded money market funds	Generally available day after sale	Stable	Not FDIC insured
T-bills	Available at maturity	Fluctuates prior to maturity	Backed by the U.S. Treasury
Certificates of Deposit (CDs)	Penalties for early withdrawal	Stable	FDIC insured
Ultrashort bond funds	Generally available day after sale	Fluctuates	Subject to bonds in portfolio (look for overall credit rating of A or better)
Stable value funds1	Generally available day after sale, may have short-term redemption fees	Stable	Subject to bonds in portfolio and insurance provider (look for companies rated A or better)

The bottom line

• Checking, savings and money market accounts are good for day-to-day expenses as well as your emergency reserve.
• Shorter-term CDs and T-bills can be used as part of your strategic cash allocation and are also good for known obligations coming due in the next three to 12 months.
• Longer-term CDs, ultrashort bond funds and stable value funds can be used as part of your strategic cash allocation and are good for known obligations coming due within one to three years.

The right choices for you, and the extent to which you include some or all of your cash in your portfolio, will depend on your particular situation and preferences.

In any event, try not to take the perennial debate over whether cash is "king" or "trash" too seriously. Cash is simply a tool—one that comes in pretty handy when you need it, so manage it with care.

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