What You Should Consider Before Investing in Cash Equivalents

considerBy Nataliya Nemtseva, Spring 2014 Student Intern

“Cash equivalents” is the term used to refer to a class of short-term low-risk investments that pay interest.  These include bank certificates of deposit (CDs), U.S. Treasury bills and other money market accounts.

While there is no such thing as a risk-free investment, cash equivalents may be the closest you can get to a safe investment.  Unlike stocks, cash equivalents do not fluctuate in value and offer a fairly easy access to cash by allowing you to withdraw the money you invested in a relatively short period of time.  Although such withdrawals sometimes carry a penalty, this penalty may not be as significant as the cost of selling your stock at a loss.  Additionally, the U.S. federal government provides some protections for investments in some cash equivalents in the event of a bank or credit union failure.  For instance, Federal Deposit Insurance Corporation (FDIC) insures up to $250,000 deposited in CDs and s money market accounts of insured banks.  For more information, please visit the FDIC website.

The downside is that cash equivalents generate a low return as compared to higher-risk investments such as securities.  Inflation further reduces the value of your investment because, over a long-term, inflation may erode the value of a low-return investment.  However, you might be able to offset the effect of inflation by investing in cash equivalents with an interest rate that at least matches the rate of inflation.  Accordingly, investing in cash equivalents is likely to preserve the money you invested, but it is not likely to make you rich.  For these reasons, concentrating your entire investment in cash equivalents for a long period of time may not be that beneficial.

Investments in cash equivalents are commonly used to diversify an investment portfolio and create a mix of high and low-risk securities.  But the right mix of investments in cash equivalents and other securities depends on your financial goals and short-term need for cash and may vary throughout your life.  For example, the closer you get to retirement the more important it might be for you to preserve your savings and your preference might therefore shift from higher risk securities to cash equivalents.  Although by itself cash equivalents might not be the most profitable class of investment, this class of investments provides a good balance to the higher risk posed by other securities.