Cash equivalents share the most important qualities of the cash in your wallet, including easy access. The two other main categories of investments for your portfolio are stocks and bonds. While these instruments usually offer more potential for gain, they also have more chance of risk. Many investors keep part of their money in cash equivalents for the sake of safety.
Characteristics of Cash Equivalents
Cash equivalents have three characteristics. Like the money in your pocket, they have a clear market value. They are liquid, meaning you may spend them easily. In addition, you may get the money relatively quickly. You may access some types — such as bank savings accounts — practically immediately. The Financial Accounting Standards Board counts other liquid investments with clear market value as cash equivalents if they mature in under three months, as do some CDs and Treasury bills.
Common Bank Accounts
Bank savings accounts and money market accounts are cash equivalents in your portfolio. Although both types are liquid, money market accounts normally limit your withdrawals to six each month. The advantages of these accounts include government insurance up to $250,000 if you hold the account at an insured institution. The disadvantages include low interest rates and fees for low balances in many money market accounts. Online accounts often have better interest rates.
Money Market Mutual Funds
You buy money market mutual funds from a mutual fund company or broker. These mutual funds are cash equivalents that invest in U.S. government or other types of securities with an average maturity of less than three months. You receive one share for each dollar invested and receive a market interest rate. Do not confuse them with bank money market accounts, even though some offer withdrawal by check. Because these funds lack federal insurance, you could lose money if the share price drops below $1. You also have to pay an annual account fee.
Certificates of Deposit
Bank certificates of deposit, or CDs, tie up your money for a specific length of time while paying higher interest than savings accounts. Only CDs of less than three months qualify as cash equivalents. Some financial institutions offer CDs for one or two months, and others allow you to dictate the exact term. The advantages include government insurance up to $250,000 when invested in an insured institution. The disadvantages include lower interest than that offered for longer-term CDs and penalties for early withdrawal.
U.S. Treasury bills, which have the backing of the federal government, come in terms varying from several days to one year. Only those that mature in under three months qualify as cash equivalents. You may purchase four-week bills through Treasury Direct. Purchase the shorter-term bills at auction through brokers, dealers and banks. Although you purchase the bills at less than face value, you receive face value at maturity. The advantages of Treasury bills include exemption from local and state income taxes.
- U.S. Securities and Exchange Commission; Beginner's Guide to Asset Allocation
- "Dictionary of Finance and Investment Terms"; John Downes, et al.; 2010
- Bankrate.com: Money Market Accounts
- Bankrate.com; Money Market Fund Investing; Don Taylor; July 1, 2005
- Bankrate.com: U.S. Treasury Securities
- Treasury Direct: Treasury Bills
- Hemera Technologies/AbleStock.com/Getty Images