Investors, We Need to Talk About Your Cash

Just a few short years ago, many investors were feeling lackadaisical about their cash holdings, and it was hard to blame them: Yields on most cash products fell somewhere between zero and abysmal.

But now that the Federal Reserve has been lifting short-term rates for several years running, cash yields have begun to compel again--at least relative to other investment types. Many money market mutual funds are yielding well over 2% these days, while longer-term CD yields are closing in on or over the 3% mark. When you consider the kind of volatility that both stock and bond investors were forced to endure in 2018, it's little wonder that many investors yanked dollars from long-term mutual funds toward the end of last year and steered the money to cash instead.

But even as many investors view cash as an attractive security blanket, it's still worth minding the nuances among various cash holdings, as well as carefully considering how much to hold in cash in the first place. If you're taking a fresh look at your cash holdings in the wake of newly impressive yields, here are some tips to keep in mind.

Do: Customize your cash allocation. Before you begin comparing the yields on various cash instruments, it's crucial to right-size your cash holdings based on your own situation. People who are working and earning a paycheck generally need to hold less cash than people who are retired and drawing from their portfolios. The virtue of holding cash in retirement is that you're buying yourself protection against having to withdraw from stocks or bonds following a big disruption in either market.

For people who are earning salaries, three to six months' worth of living expenses in cash investments is a good baseline. Tweak your cash allocation upward from that if you're a contractor (not a full-time, permanent employee). Ditto if you occupy a job that's more specialized and higher-paying, or are the sole earner in your household. And if you're on the hook for near-term extraordinary outlays (tuition payments) or saving for a short-term goal, such as a home down payment in two years, those assets belong in cash, too.

For people who are already retired, I like the idea of maintaining a cash bucket alongside the portfolio's long-term stock and bond holdings; that's the linchpin of the Bucket Approach to retirement portfolio management. You can arrive at the right amount of cash holdings by starting with your portfolio expenditures for the year ahead, then subtracting any amounts that you'll receive from guaranteed, nonportfolio sources, such as Social Security or a pension. The amount that's left over is your annual portfolio withdrawal. Maintain two years' worth of withdrawals in cash if you can't bear the idea of any part of your near-term reserves fluctuating in value. If you're slightly more risk-tolerant, you might consider building a two-part emergency fund: one year of portfolio withdrawals in true cash reserves, combined with another year or two of portfolio withdrawals in a high-quality ultrashort or short-term bond fund.

Don't: Overdo it. A guaranteed 2% to 3% yield seems pretty attractive right now, particularly when you consider that short- and intermediate-term bond yields aren't significantly higher. But graphs like this one, prepared by the investment firm Research Affiliates, depict the potential opportunity cost that investors can face by holding too much in cash. You'll see that the firm is expecting the highest returns over the next decade from those investments with the highest volatility, such as emerging-markets stocks, whereas the lowest-return, lowest-volatility investments, especially cash, are at the bottom left. Of course, there's no guarantee they'll be right in the decade ahead, but that pattern jibes with market history: Over most long-term time periods, investors have been able to earn a higher return in stocks and bonds than they have in cash. You pay an opportunity cost for peace of mind.

Do: Hold a bit extra if you're an opportunistic investor. Many active investors like to hold a bit extra in cash--above and beyond the baseline amounts outlined above--in order to put money to work on the dips. If you're disciplined, that can be a great way to lower cost basis and improve take-home returns. If that describes your strategy, just be sure you have outlined clear triggers for your potential purchases, ideally in your investment policy statement. After all, if you hold extra cash but never see fit to deploy it (and it can take nerves of steel to put money to work in downturns!), that can drag on your bottom line over time.

Don't: Hold any more in low-yielding accounts than you really need to. If you're an opportunistic investor who would like to put cash to work when stocks slump, the convenience of holding your cash in your brokerage account is hard to beat. That said, the most common cash option for investors with brokerage accounts is a sweep account, the yields on which can be incredibly low. Interest on brokerage sweep accounts have ticked up a bit recently, but are still well below other cash options. For example, Schwab was recently paying 0.33% on small brokerage sweep accounts, whereas its money market funds were paying more than 2%. That differential argues against using a sweep account as the main receptacle for your cash. It wasn't a big deal a few years ago when all cash instruments had paltry yields, but today the gap is more meaningful.

Do: Shop around for a higher payout. Yield is the most obvious differentiator among cash instruments, and it pays to shop around; don't accept what your bank or investment provider is offering without ensuring that it's in line with prevailing yields. These days, you don't have to reach to easily exceed 2%, so if you're earning well less, you're shortchanging yourself.

But be sure to read the fine print about yield, too, especially on very tantalizing ones. The accounts with the highest yields typically require you to maintain a minimum balance. Attractive "teaser" rates may also apply to the first few months you hold the account, but drop after that. Additionally, that very high yield may only to balances under a certain level, often as low as $15,000, and you'll earn less if you hold more than that.

Don't: Ignore safety and diversification in the quest for yield. In addition to reading the fine print, take a moment to think through whether you value an ironclad guarantee or are willing to go without in exchange for a potentially higher yield. Some cash instruments are fully FDIC-insured (up to the limits), while others are not. FDIC-insured accounts provide the assurance that you'll be made whole if your account has a loss; FDIC insurance covers up to $250,000 per depositor per institution. On the short list of FDIC-insured investments include checking and savings accounts, CDs, money market accounts (not to be confused with money market mutual funds), and online savings accounts.

Not on the list: money market mutual funds, or any mutual funds, for that matter. While money market fund yields have edged above FDIC-insured investments in many cases, these products are not FDIC-insured. Demand notes issued by corporations are another type of cash alternative that are not FDIC-insured. Their yields are often quite attractive relative to cash investments with FDIC backing; for example, GM "Right Notes" currently offer yields of at least 2.5%. The trade-off is that, in contrast with, say, a money market mutual fund that owns a basket of debt obligations from various issuers, demand notes are issued by a single corporation and therefore don't offer diversification.

Do: Factor in your need for liquidity. In addition to guarantees (or lack of them), liquidity constraints are another differentiator among cash holdings: If you're willing to tie up your money with a financial institution for a predetermined period of time, you'll usually be able to earn a higher return than if you'd like to have ready access to your cash. CDs will typically offer the most compelling yields of all cash instruments, but you'll usually pay a penalty if you need to crack into your holdings before the maturity date. Retirees or other individuals with ongoing cash-flow needs can employ a laddered CD strategy, purchasing CDs of varying maturities; that way something is always maturing to meet cash-flow needs.

If you're not comfortable building a ladder, however, you'll want to invest your cash in something that offers ongoing liquidity. Money market mutual funds fit the bill and their yields are getting more attractive; albeit without the benefit of FDIC protection. If you want daily liquidity, a decent yield, and FDIC protection, your best bet will tend to be an online savings account or a savings account through a credit union. The former offers FDIC protection, up to the limits, whereas credit union accounts are insured by another entity, the National Credit Union Administration. A recent scan of savings accounts on bankrate.com uncovered savings-account yields well in excess of 2%, and many of these accounts come with check-writing privileges.

Do: Consider a stable value fund if cash is part of your long-term asset allocation. If you're holding cash as part of your strategic asset allocation, rather than because you need ongoing access to your funds, you might consider using a stable-value fund to wring a higher yield from your cash. Stable-value funds, which are only accessible inside of company retirement plans, will typically yield more than the money market fund on offer inside your plan. To do so, they invest in bonds, so they're not FDIC-insured; to protect investors' principal, they employ insurance wrappers to help maintain a stable net asset value.

Just bear in mind that stable-value funds carry drawbacks. Because you can only own such a fund within a 401(k), you'll pay taxes and penalties to withdraw your money prior to retirement unless you meet certain criteria. In other words, don't think of a stable-value fund as an emergency fund unless you're already retired or close to it. Second, even though stable-value funds buy insurance wrappers to help protect investors' principal, the assets aren't guaranteed or eligible for FDIC protections.

Don't: Ignore tax effects. With cash yields as low as they have been, it has been hard to get excited about the taxes you'll owe on any income you receive from those accounts, even if that income is dunned at your ordinary income tax rate. But now that yields are heading higher, the tax effects of sizable cash allocations can be more meaningful, at least in real-dollar terms. Investors in higher tax brackets might consider a municipal money market mutual fund, which invests in the short-term obligations of various municipalities. Such funds pay income that's generally free from federal tax; if you buy a muni money market fund dedicated to the state in which you live, your income distributions will also escape state tax, too. Right now, the yields on muni national money market funds don't look especially attractive rather than taxable money funds, but that relationship can change quickly, so high-income investors should monitor it.