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Thinking About Cash

By: Jason Whitby

By: Jason Whitby, CFA®, CFP®, AIF®

If you are wondering what to do with your cash, you aren’t alone. Just like 2002 when cash investment yields plunged below 2%, people are again feeling the pain from the too often dismissed issue of reinvestment risk. Technically speaking, reinvestment risk is the risk that cash from an investment may not be able to be reinvested at the same or better rate. If your favorite 5% CD just matured and you cringe at the 2% offered today, you know what I’m talking about. So while everyone was stressed out over the S&P 500′s rollercoaster ride, many people are getting sucker-punched by the one-two of rising prices and lower cash investment yields. So here are a few ideas I would suggest you consider when reviewing what to do with your emergency cash reserve, spending cash and ear-marked cash for big ticket items such as a new car or a down payment for a house.

Appropriate Levels of Cash

The first item to consider is also the most important. When cash yields are so low it hurts, make sure you don’t have more cash on hand than you really need. Any cash you have that isn’t for emergencies, paying monthly bills or a clearly-defined future expense should be considered surplus cash. Surplus cash can be used to pay down your debts or applied to your investments and savings plan. How do you know what is surplus cash? Everyone really should have 3 to 6 months of cash available in case of emergencies. If you are saving for a house or a car, the target cash reserve is clear. Cash above these reserves should be considered surplus cash and can create cash drag on your net worth. Cash drag can be a real issue for many well intentioned individuals. If you are losing sleep over your cash balances, you likely have too much or too little.

Internet Banks and Shopping Online

The next suggestion is shopping for the best banking deals online. Gone is the 1-year certificate of deposit with a 5% APY. According to http://www.bankrate.com, the nation’s highest-yielding 1-year CD is 4.15% and the average is 2.05%. The big difference in CD yields can usually be attributed to being internet only and a motivated institution. Simply by agreeing to handle all of your banking needs online, you can increase the saving account yields from 2% to 3%. If you combine this internet only option with a 1yr CD from a motivated lender, you can get yields over 4%. But just taking the highest yielding CD without concern for the lenders health can be a mistake. There is usually a good reason why some lenders are more motivated than other to get your deposits. Do you really want to be fighting with a failed bank and the FDIC when you need the cash for college expenses or home improvements or paying your taxes? Banks do go under as the recent run on Bear Sterns shows. A repeat of the S&L crisis is not completely unimaginable. If you are justifying a high CD by the “FDIC”, be sure you can wait for FDIC to pay. When shopping online for a great banking deal stick to names you can trust.

High Yield Checking Accounts; “It’s a Real Deal, Really!”

At least that’s what the advertisement stated for this 6.01% APY High Yield Checking account. However, when I called to inquire, the “real deal” had already been lowered to 5% APY, which is still pretty darn good. So what is the catch? Why does the high yield checking at this credit union pay 5% while their regular checking pays just 0.25%? Here are the general rules you have to follow to get the higher rate: 1) You must use the debit card 12 times each month to purchase something, 2) You must establish at least one electronic transaction, 3) You must elect online statements, 4) You only receive 5% on balances up to $25,000 with no minimum. If you can live within these restrictions, shopping for a high yield checking account seems like a good option. Of course banks can lower their rates without notice in which case you can take what they give you or go through the hassle of moving again. Sort of a musical chairs routine if you will. Of course the bank is hoping you mess up and only use the card 10 times which means you get the 0.25% instead of the 5%. But if you do have the time and are willing to abide by the rules, a High Yield Checking account can make sense.

Position-Traded Money Funds and Tax Exempt Money Funds

Another item is to review your current options and your after-tax yield. Here are five different possibilities you could have at the same firm.

As of 5/15/08

    7-Day Current Yield
1 Position-traded Money Market Fund Value Advantage Money Fund 2.67%
2 Position-traded Money Market Fund Municipal Money Fund 2.16%
    7-Day Current Yield
3 Sweep Money Market Fund Advisor Cash Reserves 2.32%
4 Sweep Money Market Fund Municipal Money Fund 1.81%
    Interest Rate
5 Bank Deposit Sweep One Taxable Interest 0.15%

This table clearly shows how switching from the bank deposit option #5 to the sweep money market fund #3 and then to the position-traded money market fund #1 can improve your taxable yield from 0.15% to 2.67% with little additional risk and effort. Why would someone accept a taxable 0.15% yield when they could be getting 2.67%? They simply didn’t know. Another benefit can be seen if we compare the taxable money funds to the tax-free money funds. At these yields, most individuals above the 15% marginal tax bracket will have more money after Uncle Sam’s cut by simply moving to the tax-free options. For example, if you are in the 25% tax bracket, your after-tax yield for option #1 would be 2.0% compared to the tax-free yield of #2 being 2.16%. So before you go moving your money to someone new, be sure to investigate all of the options at your current bank, credit union and brokerage firm.

Cash Rewards Credit Cards

On a final note, be sure to take advantage of cash rewards credit cards as long as they have no annual fee and you pay off the balance monthly. Some cash rewards cards offer as much as 1% on every purchase. If you charge $5,000 each month on a cash back rewards card, you will get $600 back at the end of the year. So maximizing your return on cash is not exclusive to savings but also can be applied to your expenses. After all, every little bit can help.

Overall, Keep it Simple

Too often during difficult times, people tend to deviate from the basic premise that cash should be risk-free and liquid. They end up getting sold an annuity or perhaps some “cash equivalent investments” which aren’t really that equivalent. For example, some recent blunders have been floating-rate bonds and ultra-short bond funds which have seen their values drop 10% and 30%, respectively. Another nightmare was the cash substitutes known as auction-rate notes. These securities were sold as cash but then some investors couldn’t sell them at any price and were forced to liquidate stocks or even take out a high cost loan in order to pay the IRS. Both options were horrible tradeoffs considering the auction-rate notes typically provide a slightly higher yield than money market funds.

Keeping cash simple makes the most sense. I hope you can take advantage of one or all of these ideas and please don’t hesitate to ask me or your advisor if you would like some additional information.