Cash Equivalents

Cash equivalents are assets that can be converted to spendable cash quickly and with little or no risk that the amount will have changed. They make up the cash portion of the three broad asset classes an investor allocates among: the SEC's investor glossary defines an asset class as investments with similar characteristics and names stocks, bonds and cash as the three main ones. Cash equivalents are how the third of those is actually held, since almost nobody holds physical currency in size.

The phrase is a category label rather than a term with a single official meaning for individual investors. The SEC's investor glossary, which runs to several hundred entries, has entries for cash and for a cash account and none for cash equivalents. In corporate financial reporting the phrase is narrower and more precise. Describing US accounting standards, the SEC has stated that they define cash equivalents as "short-term, highly liquid investments that are readily convertible to known amounts of cash and that are so near their maturity that they present insignificant risk of changes in value because of changes in interest rates", and that "generally, only investments with original maturities of three months or less qualify under that definition." That is a reporting convention rather than a rule for households, but it is a good instinct to borrow, because it puts the emphasis where it belongs, on how soon the instrument turns back into a known amount of money.

Three properties define the category, and a candidate has to have all three. It has to be liquid, meaning convertible to spendable money on short notice. It has to have a stable value, meaning the amount you get back is known in advance rather than set by whatever a market will pay that day. And it has to have a short horizon, because the further out the maturity, the more room there is for interest rates to move the price before you get there.

Applying those three tests sorts the field quickly. A savings account, a money market deposit account and a certificate of deposit maturing soon all pass, as do Treasury bills and money market funds. A short-term bond fund fails the second test, narrowly but genuinely: its share price floats, so an investor can need the money in a week when the price is down. That is a small risk in ordinary conditions and it is not zero, and treating a bond fund as cash is one of the more common ways an emergency reserve turns out to be smaller than expected.

The protections inside the category are not uniform, and this is where the category label does the most damage. A bank or credit union deposit is federally insured within statutory limits. A Treasury bill is not insured at all, because it is backed by the full faith and credit of the United States instead. A money market fund is a security rather than a deposit, and it is not insured either. Two of these carry near-identical names and are frequently sold on the same screen, and the distinction between a money market fund and a money market account is covered in full on the pages for each. The honest summary for this page is that "cash equivalent" describes how something behaves, not how it is protected, and the two questions have to be asked separately.

Then there is the risk the category is named after not having. A holding that cannot fall in dollar terms can still fall in what it buys, every single year, and over a long horizon that erosion is the dominant risk of holding cash rather than a secondary one. Our page on inflation covers the mechanism. The practical consequence is that the right question about a cash balance is not whether it is safe but what job it is doing: money needed within a few years belongs here because the alternative risks are worse, and money not needed for decades is being asked to do a job that cash equivalents cannot do.

Two smaller points round out the picture. Reinvestment risk works in the opposite direction from price risk: short instruments mature constantly, so a falling-rate environment repeatedly replaces a good yield with a worse one, and the stability of the principal is bought with instability of the income. And the yield on cash equivalents is generally taxed as ordinary income in a taxable account, which takes a larger bite than the rates that apply to long-term gains and qualified dividends, so the after-tax return is lower than the quoted one by more than an investor may assume.

Money is placed in an instrument that either has no market price to move, such as an insured deposit, or has so little time left to maturity that its price cannot move much. It earns interest at a rate that resets frequently, and it converts back to spendable money on demand or within days.

A hypothetical illustration of what such a holding actually earns. An investor keeps a $60,000 reserve in cash equivalents for a year. Suppose the holding yields 4 percent and consumer prices rise 3 percent over the same year, both figures chosen for the arithmetic rather than as a forecast.

At the end of the year the balance is $60,000 multiplied by 1.04, which is $62,400. To compare that with the starting amount in like-for-like purchasing power, divide by 1.03: $62,400 divided by 1.03 is $60,582.52. The real gain is about $583, which is roughly 0.97 percent. Positive, and small.

Now change one number. Suppose the same $60,000 sits in an account paying 0.5 percent while prices rise 3 percent. The balance becomes $60,300, and in start-of-year purchasing power that is $60,300 divided by 1.03, or $58,543.69. The investor is about $1,456 worse off in real terms, having lost nothing at all in dollar terms. Nothing went wrong, no market fell, and the reserve did its job of being available. The gap between the two cases is entirely the rate on the account, which is the one variable in this category that is worth shopping for.

What cash equivalents do well

• The amount is known in advance, so money needed on a date can be committed to that date.
• They are available quickly, which is the whole point of an emergency reserve.
• Holding near-term spending here means a market decline never dictates when long-term holdings are sold, which is the mechanism behind sequence-of-returns risk.
• The rate is one of the few things in investing that is both easy to compare between providers and worth several hundred dollars a year on an ordinary balance.

What they cannot do

• They lose purchasing power whenever the after-tax yield is below inflation, which is common and can persist for years.
• The interest is generally taxed as ordinary income in a taxable account, so the after-tax return is lower than the quoted yield by more than most people assume.
• Income is unstable by design: rates reset constantly, so a comfortable yield can halve without anything being wrong.
• The category name implies a uniform level of protection that does not exist, since insured deposits, Treasury obligations and money market funds are safeguarded by three unrelated mechanisms.
• Held for a long horizon they have a large opportunity cost, which is the return given up by not owning growth assets.