Money-Markets, CDs, and Bonds: The Ups and Downs of Stashing Your Cash
Personal_Finance / Savings Accounts Jan 26, 2012 - 07:29 AM GMTBy: Money_Morning
Don Miller writes:
In today's volatile markets many investors are faced with the same troublesome question - "Where should I park my cash?"
In fact, investors have withdrawn a net total of $328 billion from the stock market since 2007, according to Strategic Insight.
Ever since, a big portion that cash has been looking for a home.
It seems simple enough, but investors are finding the answer to be more complicated than they imagined...
Thanks to our friends at the Federal Reserve, interest rates are at record lows. In fact, they're so low that most investors are getting practically nothing in returns.
Meanwhile, the stock market has put on a New Year's rally, rewarding those who were willing to jump in while leaving cautious investors wondering if they're holding too much boring old cash.
However, in order to have an adequate safety net, your cash on hand should be enough to cover about a year's worth of expenses, according to Shah Gilani, a retired hedge fund manager and Editor of the acclaimed Wall Street Insights & Indictments newsletter.
"That's a good safety net," Shah says.
But no matter how much cash you hold, you still have to balance your need for higher returns against your risk tolerance.
Because whether you're thinking "safety first" or are tempted to reach for a little more yield, the choice you make might determine whether you're able to sleep at night.
Three Places to Park Your Cash
With that in mind, here's a look at three of the most popular places to park your cash.
Money Market Mutual Funds: Average one-year return: 0.04%.
Despite their current low yields, money-market mutual funds (MMMFs) tend to make sense for investors who want to be able to move into the stock or bond market at a moment's notice.
In that sense, MMMFs are liquid.
What's more, with a money market fund, you access your money quickly by writing checks or using an ATM card.
Most mutual fund families and brokerages offer "sweep" accounts, which automatically move money from stock and bond sales into MMMFs.
These funds currently hold approximately $3.2 trillion of investors' money in highly liquid securities like certificates of deposit and government securities, according to Bloomberg News.
But unlike bank deposits, MMMFs are not insured by the Federal Deposit Insurance Corp. (FDIC).
That's a key point that is lost on most investors. These funds can "break the buck," potentially exposing investors to loss of principal.
In fact, when Lehman Brothers Holdings Inc. failed on Sept. 15, 2008, the Reserve Primary Fund was stuck with $785 million of worthless commercial paper, leaving it without enough assets to cover its investors.
This announcement sparked a run on the fund, as people raced to withdraw their money before it was too late.
The panic soon spread to other money-market funds as investors pulled $400 billion out of the money-markets in less than two weeks.
The situation was finally defused only after the Fed and the U.S. Treasury promised to backstop the entire industry.
Now with the Eurozone in a similar liquidity crunch, the largest U.S. funds have moved aggressively to reduce their exposure to European debt by shedding their investments in euro- region banks, Bloomberg reports.
Still, the 2008 debacle was a stark reminder that danger can lurk in even the most conservative portfolios.
Bank Certificates of Deposit (CDs): Average yield on one-year CD: 0.44%.
CDs are debt instruments with a specific maturity, which run anywhere from three months to five years. CDs are considered to be safe because most are offered by banks, where they are insured for up to $250,000 by the FDIC.
But in order to get the best rates you have to deal with the old bugaboos: longer maturities and early-withdrawal penalties.
For instance, you can get 0.99% on a one-year CD according to Bankrate.com. Or you can bump the rate up to 1.8%, by locking your money up for five years. You can choose to redeem the CD early, but you'll have to pay a penalty.
So while CDs may pay more than money markets, your cash is essentially off-limits until the CD matures.
Short-Term Bond Funds: Average one-year return: 3.37%.
Bond funds that pool investor capital are an efficient way to buy bonds in small doses. They also offer investors a degree of diversification to minimize their risk of picking a bond from a deadbeat company.
The yields, however, are much juicier than those of money-market funds.
In fact, investors poured more than $160 billion into bond funds in 2011, according to Strategic Insight.
But the Net Asset Value or NAV of a bond fund does fluctuate with interest rates movements of the bonds held inside the fund.
Generally, short-term bond funds are less risky than long-term because they hold up better in a rising-interest rate environment. But even short-term funds with high-quality holdings can take principal losses if interest rates rise quickly.
And since they are not insured by the government, you can't be sure how much of your original investment will still be intact when you go to sell them. You also have to pay an ongoing expense to own the fund and you may also have to pay a commission or "load."
Short-term bond funds that get high marks from Morningstar Inc. (Nasdaq: MORN) include T. Rowe Price Short-Term Bond (MUTF: PRWBX) and Vanguard Short-Term Bond Index (MUTF: VBIXS).
The Bottom Line
Of course, all of these investment options for your cash come with risk. You'll lose out to inflation with CDs. Meanwhile, with bond and money-market funds there is the risk that you could lose at least part of your principal.
If you want to hedge your bets - and improve your flow of cash - until the market outlook improves, Gilani recommends adding a dash of high-yielding, big-cap stocks.
"As a very good defensive strategy, establish a core portfolio of five to seven very strong, liquid, cash-flowing companies," he said. "Avoid Europe, avoid commodities and avoid emerging markets for a couple of quarters to see where we are headed in terms of Europe and China."
But he also notes, cash will never be out of style.
"Nothing makes people bow so low as cash," said Gilani. "Cash will always be king - and the kingmaker."
Bonus Play: Here's another way to put your cash to work...
It's called the Geiger Index. And in 2011 it rewarded investors an average gain of 4.94% every 34 days. This year it's already provided investors with three triple-digit gainers-just 25 days into the New Year.
It's surprisingly safe too - 21 of 22 trades were winner last year
And you'll be surprised to learn exactly how this index works. Take a look. No wonder it's so safe.
Source http://moneymorning.com/2012/01/26/money-markets-cds-and-bonds-ups-and-downs-of-stashing-your-cash/
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