your 401(k) #8: cash & inflation
Diving into asset class #1: CASH!
As mentioned in the intro video to asset classes, cash could mean an actual cash balance in your savings account, piggy bank, wallet, etc. But when it comes to investing, there are other securities, or types of investments, that classify as cash. They all share three characteristics, or the 3 Ls to make it easy:
- Cash assets are short-term securities, which means you’re only tied up in the investment contract for a short period of time. This short time frame allows cash assets to be easily and quickly bought and sold.
- Low risk
- Thanks to their high turnover, cash assets are considered low risk. There are always buyers and sellers for them, so their values fluctuate less than stock prices.
- Low return
- I’m sure you’ve heard the phrase “with risk comes reward”. Because cash investments are considered so low risk, they’re also low return. In other words, they don’t pay out much because the chance of you losing money is so low.
Due to these three characteristics, financial advisors often recommend cash investments to provide stability and liquidity to your portfolio, or investment account.
If you have most of your money invested in stocks, you could put the rest of it in something more stable, like cash assets. That way, if the stock market drops, your cash investments would help keep your overall portfolio loss to a minimum. If you’re worried about the stock market dropping, moving some of your money into cash assets may be a smart idea.
Here's some simple math. Let’s say you have $50k in your retirement account and it’s split like this:
$50,000 total = $30,000 in stocks + $20,000 in cash assets
If the stock market drops 30% ($30,000 → $21,000) and your cash assets return +1% ($20,000 → $20,200), you’d only end up down 17.6% for the year ($50,000 → $41,200). That's a hell of a lot better than the full 30% that the stock market is down.
On the flip side, cash assets are low return and may weigh you down when the stock market is surging. For example, if stocks go up 10% ($30,000 → $33,000) and cash goes up 1% ($20,200), your combined portfolio would only be up 6.4% for the year ($50,000 → $53,200).
Having liquid investments, or ones that you can easily buy and sell, is valuable for two reasons:
- Liquidity ensures that you won’t get stuck in a crappy investment that loses money. If you want to sell it, there are buyers that will take it off your hands.
- Liquidity provides something I like to call “dry powder”. Banks, big investment firms, hedge funds, etc will sometimes keep a cash reserve, that way they can buy stocks or other investments when opportunity strikes.
- For example, if you had had “dry powder” or cash to spend when the market bottomed out in 2009, you could have bought some incredible companies’ stocks at rock bottom prices. Since reaching its low in 2009, the S&P 500 has nearly tripled. Imagine if you had had extra cash on hand to buy stocks - you could have tripled your money!
So what’s the downside? INFLATION. Inflation is the increase of prices over time, and it decreases the value of your money, or how much each dollar can buy. Have you ever heard your grandparents talk about how cheap milk or gas used to be? That’s inflation at work! Historically, prices increase an average of 2-3% per year in the United States.
Here’s an easy to understand illustration:
Let’s say there’s a gadget that costs $100 today. If you have a $100 bill, you could buy it.
A year from now, that same gadget may cost $103, or 3% more, due to inflation. If you didn’t invest your $100 bill, it’d still be worth just 100 bucks. In that case, you wouldn’t be able to afford it anymore.
Even if you invested that $100 in cash assets, you’d still come up short. As mentioned in the video, cash investments are currently returning less than 1% per year. So your $100 might grow to $101 if you’re lucky, but you’d still be 2 bucks short.
Now imagine how many bucks short you might be after 40 years of inflation! You wouldn’t be able to afford anything! If all you’re doing right now is saving money, your bank account balance may be going up, but the value of every dollar in it is decreasing by an average of 2-3% per year. That’s some serious value deterioration! And precisely why it is so important to invest your money. Just saving will not cut it when it comes to your golden years.
If you want to invest some of your money in cash assets, how can you do it?
CDs - Certificates of Deposit
When you buy a CD, you are loaning money to a bank for a short period of time. When the CD matures, or expires, the bank will pay you back with interest on top.
You can buy CDs directly from a bank or from a broker. CDs come in all shapes and sizes, maturities and rates. You can buy CDs for as short as a month or up to five years. What’s best for you depends on how long you’re okay with that money being tied up. Once you buy the CD, you can’t touch those funds until the maturity date, otherwise you'll have to pay a penalty.
short-term Treasuries aka t-bills
T-Bills are similar to CDs, but in this case, you’re loaning money to the government for a short period of time. Now I know a lot of people distrust the government, so you may be wary of loaning Uncle Sam money. However, T-Bills are considered very safe investments.
One thing to be aware of, though, is that there are three types of Treasuries, and you don’t want to get them confused.
- Treasury bills have maturities less than 1 year.
- Treasury notes are for 2-10 years.
- Treasury bonds are for 10-30 years.
If you’re looking for a cash-like investment, T-bills are the ones you want. Why? Because they fit the 3 Ls - Liquid, Low risk, and Low return.
If you’d like to invest in Treasuries, you can buy them from banks, brokers/dealers, and directly online at: www.treasurydirect.gov. You may also be able to invest in Treasuries in your retirement account. Look for investment options called “ST Treasuries”, “1-year Treasuries”, or “T-bills”.
These are short-term loans to companies. These investments aren’t typically available to the Everyday Investor due to multiple restrictions. Commercial paper is mainly traded by large institutional investors like banks and money managers.
Money market funds
Last but not least are funds that invest in a mixture of cash-like assets. Most retirement plans have at least one option. Look for “money market fund” (“MMkt” or “MMF” for short) or “stable value fund”. You can learn more about how these investment funds work in the next post.
*** Note: A money market fund and a money market account sound very similar, but they are different in a few respects. When you put money into a money market account, it’s simply a high yield savings account that is insured by the FDIC. When you put money in a money market fund, that fund company uses your money to invest in cash-like securities. Because of this, money market funds are not FDIC insured. ***
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Disclaimer: Make sure to thoroughly read your Summary Plan Description and/or consult a financial advisor for help before buying into any of the above cash investments. It’s very important to be aware of the potential risks involved no matter what kind of investment you’re considering.