Even though it seems to defy conventional wisdom, cash or cash equivalents can be an excellent investment. There are even some cases where cash is the best investment that a person can make.
The reason why cash is often an excellent investment is that it is liquid. That means you spend it immediately or right away. You will not have to pay a fee or take any special action to use cash. Therefore you can use it to cover expenses right away or take advantage of an opportunity.
Many investment experts recommend that families and individuals keep a cash reserve. Such a reserve should consist of several thousand dollars that you can access quickly. This cash can help you avoid debt and provide financial security. The creation of a reserve is one the best and most basic investment moves that you should take.
Advantages to Cash
The reason you need a reserve is all the advantages that cash has. The first and most obvious is that spending cash will not cost you anything. You will not have to pay interest on it and you will not accumulate further debt by using it. Spending cash will not diminish future earnings because you will not need to pay it back.
Having it available can help you avoid falling into the trap using debt instruments such as credit cards to cover day to day expenses. It can protect your credit rating and your ability to borrow. Even if you borrow, having a large amount of funds available can increase your ability to borrow and your credit rating
Disadvantages to Cash
There are some serious drawbacks to cash that you should be aware of. The first is inflation, money loses value, the usual inflation rate is 4% but inflation has risen as high as 19% at some points in American history. That means any funds kept as cash will lose value.
Another disadvantage is that cash will not earn any extra income on its own. Equities and securities will earn interest which can make up for inflation and increase in value. Most cash investments will only earn a low interest rate that is sometimes less than the rate of inflation.
Finally liquid funds will increase your income tax liability. You will have to report those funds on your tax return. That will probably increase your tax bill and could decrease your income.
How to Invest in Cash
The key to using cash as an investment is to find vehicles that function like cash but lack some of its drawbacks. You should always keep cash funds in insured bank accounts or investments such as CDs or money markets. These instruments are insured by the FDIC so there is little chance the funds can be lost. Many of them will pay a fairly good rate of interest.
More importantly you should be able to access these funds through a debit card. Therefore you can use them to pay bills, cover expenses or invest. This means there is no reason for a person to keep large amounts of actual cash around. There many excellent liquid investments anybody can access.
Even though cash can be a good investment you should limit how much you keep available. You should set a limit of funds you will hold in your cash reserve. If the funds rise above that you should reinvest it in a tax-deferred vehicle such as an IRA, an annuity or an insurance policy.
Persons over 59½ years old should also seriously consider using an insurance policy as a cash reserve because funds in one are tax deferred. Younger people should avoid this because of the tax penalties the IRS puts on retirement investments.
Inflation is something that most investors will not think about before it is too late. Unfortunately inflation can destroy the value of almost any investment and turn potential returns into losses. Inflation-adjusted investments are designed to preserve value.
How Inflation Destroys Investments
Inflation’s affect on investments can be devastating. Take the case of a bond that pays 3% interest, if the rate of inflation is 4% the bondholder actually loses 1% of the bond’s value. If the inflationary period continues for ten years the holder would lose 10% of the bond’s value.
Even though the rate of inflation in the US is quite low right now it can go up. In 1972 the US inflationary rate was 3.25% but by 1980 it had risen to 13.5%. That meant the inflation rate was ten times the standard interest rate on vehicles such as bank accounts. This was not even the highest inflation in US history, in 1946 inflation hit 19%.
Everybody needs to have at least a few inflation-adjusted investments to protect his or her investments. There is no guarantee that high inflation will not return at some point and destroy your investments. Such vehicles are a good insurance policy against this scourge.
Adjustable Rates and Principals vs. Inflation
The most common inflation-fighting mechanism is an adjustable interest rate. The interest rate changes to match the rate of inflation that stops an investor from losing value when the value of money falls.
A popular investment that employs an adjustable rate is TIPS or Treasury Inflation Protected Securities issued by the US government. TIPS pay interest on an inflation-adjusted principal so they never lose value. In this arrangement the value of the bond is based on the current rate of inflation not the purchase amount. A big advantage to these securities is that you can purchase them directly from the Treasury.
There are also inflation-adjusted municipal bonds. These use a similar mechanism to adjust the value or the interest rate to compensate for the erosion of value. The Treasury also issues a class of inflation adjusted bonds called I bonds.
Other Inflation Fighters
Another popular means of compensating for inflation is an indexed investment. In this arrangement a portion of the investment is placed in an index of stocks. Since the stock market usually increases in value at a rate that is much higher than the rate of inflation it will make up for most losses.
Indexed annuities and indexed insurance policies are designed to prevent the loss of insured investment income in inflationary periods. Fixed annuities in particular can be very vulnerable to rising rates. The typical indexed annuity combines an index and a fixed-annuity to guarantee income.
Some indexed annuities even offer a guaranteed rate of return. Under this mechanism the return remains at the highest level even if the market falls. This locks in higher returns to compensate for inflation.
How to Use Inflation Adjusted Investments
The average person should have at least 10% of his or her retirement investments in some sort of inflation-adjusted vehicle. This should compensate for normal inflation. In an inflationary period it is often a good idea to transfer a large percentage of your money into adjusted vehicles.