RETHINKING CASH

Just a few years ago, keeping cash in a money market account or certificate of deposit was only slightly more appealing than keeping it in a jar in the basement. Times have changed. Since the Federal Reserve began raising short-term interest rates in 2004, the outlook has shifted enough that most people might want to reconsider how and where they are keeping their cash.

Cash is a vital component in a comprehensive financial strategy, and many experts recommend keeping enough on hand to cover several months of living expenses in case of an emergency. But with rising interest rates, some individuals might want to do more with their cash than keep it for a rainy day. Here are some factors to consider.

Money market accounts and certificates of deposit are paying higher interest rates than in years past, making these types of instruments more appealing than they were before. In 2003, a six-month certificate of deposit was paying a 1.19% annualized rate, the lowest on record and less than one-fifth the rate offered in 2000. But the rate has been creeping upward. It reached 3.8% in 2005 and was on pace to return more than 4% in 2006.

Of course, there are penalties for withdrawing money from a CD before it matures, so you may not want to put money in a long-term CD if you might need to access it in a hurry. But keeping cash in a bank savings account no longer has to be the default choice.

When interest rates rise, it might be time to reconsider the amount of risk you have assumed in pursuit of higher yields. Stocks and bonds are typically more volatile than cash equivalents, and principal and interest are in no way guaranteed. By contrast, bank savings accounts, CDs and money market accounts offered by banks are insured by the Federal Deposit Insurance Corporation for up to $100,000 per depositor (per institution) in principal and interest. This certainly does not mean that investors should abandon the stock market and put everything in the bank. Most people still need to own securities in order to help meet their long-term financial goals. But it bears noting that interest rates are increasing on some types of instruments that carry zero risk for sums under $100,000. Individuals who have been carrying additional investment risk during recent years to help offset the disappointing returns from cash might want to consider rethinking their risk level.

It is critical to consider investment returns in light of inflation and taxes. If an investment earns 5% in a given year and inflation for that year is 3%, the real rate of return from the investment is 2%. For an individual in the 25% tax bracket, the purchasing power of the account would show an after-tax return of 0.73%.

Over the past 25 years, inflation has averaged 3.35%. In other words, an investor would have needed to earn 3.35% just to keep pace with inflation during this time period. Of all the risks that face an investment portfolio, inflation may be the greatest. Over the past 51 years, there has not been a single year when inflation did not reduce the spending power of the U.S. dollar.

That being said, inflation has been fairly low recently. The Consumer Price Index rose a scant 0.2% in February, and other indicators seem to point toward continued low inflation, according to the Bureau of Labor Statistics. Low inflation can further raise the appeal of cash equivalents and short-term vehicles because of the potential for higher real returns. Taxes have also gone down in recent years, but they still take a toll on investment returns. It’s critical to know and understand the tax implications of every investment decision you make.

Cash, cash equivalents and other short-term investments play an important role in your portfolio. If you have redirected your cash during the past few years because of low interest rates, now may be the time to give cash a greater role in your portfolio.