Cash is a liquid asset that can be said to earn an investment return equivalent to that of the deposit rate. Cash is also commonly known as a country’s physical currency or legal tender which can be exchanged for goods and services. Cash in hand generally does not represent an investment, but rather, a means of making small, discretionary expenditures. Cash is also commonly classified to include cash equivalents/investments which are highly-liquid, low-risk assets that are readily redeemable over a horizon of fewer than 90 days. Cash investments include demand deposits, time deposits and money market funds. Although cash provides a high level of capital security, the returns are relatively low compared to other investments.
Demand deposits include checking and savings bank accounts. As suggested by the name, demand deposits can be withdrawn without any advance notice and are not required to be deposited for a certain period of time. The higher accessibility of demand deposits cause the interest rate to be lower than other cash investments. Moreover, various fees can be charged for maintaining the account.
Time deposits have withdrawal limitations as they have to be deposited for a predetermined amount of time and can only be withdrawn in full at maturity. Fixed or term deposits are examples of time deposits. Time deposits command a higher interest rate compared to demand deposits as capital is tied up. At maturity, a depositor can withdraw the deposited funds and interest earned or roll-over the savings into a new time deposit.
Money Market Funds
Money market funds are short-term debt securities that include government bills and commercial paper. U.S Treasury Bills is an example of government bills. T-Bills are backed by the U.S government and have maturities of 1 month, 3 month or 6 months. Banker’s acceptance is an example of commercial paper and represents a firm’s promise, backed by a bank, to make future payments. Banker’s acceptance are usually traded at a discount from face value on the secondary market.
Why is cash important?
Cash represents the most conservative holding in an investment portfolio. Cash investments can be used as an emergency fund or as an immediate deployment to investment opportunities that arise suddenly. While the returns from having cash as an investment are low, this is comensurated by the riskless nature of cash. On a more defensive end, another way of understanding the importance of cash would be to imagine having a fully vested portfolio with no cash. As financial markets sway unpredictably, an investor may be forced to liquidate his portfolio at inopportune times, hence realizing a loss, to raise cash for his own needs. An investor who has set aside a reasonable amount of cash, on the other hand, would have the ability to buy more securities at lower prices when the market comes off – instead of being forced to sell what he already holds.
Cash, of course, is not truly riskless. One’s bank deposits are in jeopardy if a bank faces a bank run. This is because of the way banks operate – they leverage on deposits to generate profits (How Banks Make Money). Such systemic shocks to the banking industry, however, are few are far between.
A balance between cash and investments in a portfolio is always a subjective one. An intuitive approach, however, would be for younger investors to hold more investments versus cash and for more senior investors to hold more cash versus investments. This is largely due to the timeframe investors at different stages of their life have in terms of waiting for their investments to pay off, and the different needs (medical, household, etc.) they have.
Time Value of Money
A good way to understand the value of having cash in technical terms is the concept of present value versus future value. Cash in the hand is always more valuable than the same amount of cash at a later date. This is because cash in hand now can be invested to result in a net value greater than the cash that might be received at a later date.
To illustrate, option A (receive $1000 now) and option B (receive $1000 1 year later) are weighed:
Option A: The investor would invest the $1000 at a hypothetical risk-free time deposit rate of 2%. In one year’s time, the future value of the $1000 now would be $1000 X 1.02 = $1020. This is certainly the better option given that the investor would receive $20 more one year later compared to option B.
Option B: Conversely, the above formula could be worked backwards for the $1000 to be received in one year’s time. The present value of the $1000 to be received one year later would be $1000/1.02 = $980.40. Clearly, option A with a present value of $1000 would be the better option.