What is the Cash and Cash Equivalents core asset class? Besides potential diversification, why invest in very low-return CCE? How does your life-cycle phase impact cash investments? What about personal circumstances and cash flow needs? Does one’s risk tolerance impact cash holdings?
“What is Cash and Cash Equivalents (CCE)? Why is it a core asset class?”
CCE covers liquid assets, usually with maturities under one year. Liquid, safe, low volatility, but also with very low investment returns.
It is considered a core asset class, due to the importance of maintaining some liquidity. CCE is very useful for emergency reserves. As well as short-term financial objectives, cash outflow requirements, and to have on hand for investment opportunities that arise.
“What are the CCE considerations for those in the Accumulation life cycle phase?”
Accumulators tend to be relatively young, just starting their careers. With little wealth or CCE on hand.
While CCE provides little return, there are reasons why Accumulators need CCE in their portfolio. Compared to the other life phases, in relatively higher percentages of the asset allocation.
“What are the CCE considerations for those in the Consolidation phase of life?”
Consolidators are typically older, in the prime of their careers and earnings. They have some wealth accumulated and cash inflows should cover recurring outflows. Consolidator cash requirements are much different than for an Accumulator.
However, CCE still is important. In meeting short-term financial objectives, such as buying a new home or paying for a child’s education. Also, in this phase of life there are often investment opportunities. It is useful to have liquidity on hand to take advantage.
“What are CCE considerations for those in their Spending phase of life?”
CCE issues for Spenders also differ from Accumulators and Consolidators.
Spenders are close to retirement and want to enjoy life. They probably have wealth accumulated, but may no longer have employment income to increase their capital. They may wish to increase their stability and portfolio liquidity, including increasing cash balances.
While some costs are no longer an issue in retirement, such as mortgage payments, other new expenses may emerge. Health care, world travel, helping finance children and grandchildren. Again, having that certainty of CCE investments is often desirable for Spenders.
“How can personal circumstances impact CCE allocations?”
Many personal issues fall under a life cycle phase. But some may be common across many phases of life.
Regardless of age, people often have short-term planned expenditures. For an Accumulator, getting married, having a baby, buying that first home. For a Consolidator, maybe a lake house or rental property. Sending a child to college. For Spenders, a trip to Europe.
There are also the unplanned costs. Job loss, vehicles that need replacing, health issues. Part of the emergency reserves is held to cover these unforeseen expenditures.
Tied in to unplanned costs can be the type of job you hold, where you live, etc. If you work in a cyclical sector, such as oil and gas, maybe you have strong employment in boom times. However, if the oil industry suffers, you may be prone to unemployment. If you live in the Caribbean, maybe you run the risk of hurricanes. That can also impact employment or repair costs.
“How does one’s risk tolerance impact the CCE allocation?”
Some people have a high risk tolerance. They will want the bare minimum in CCE, due to its low returns. If there is an actual problem, they will figure it out then. For now, not a consideration.
Others may want to have more than might be necessary in CCE. They sleep better knowing all possible problems can be covered.
Where you are in your life phase, your personal circumstances, and personal risk tolerance, can all impact the amount you allocate to CCE. There is no “one size fits all” for CCE. Consider your unique situation and allocate based on that.
In Asset Allocation: Cash (Part 1), we saw how your life cycle phase and risk tolerance significantly impact your target asset allocation to cash equivalents.
I do not think it prudent to allocate a percentage of capital to cash. Better to determine a fixed amount you wish to maintain in cash. Then translate into a percent allocation for your overall target asset allocation.
The amount of assets you keep in cash depends on a few factors.
Needs and Opportunities Impact Cash Allocations
Cash for Planned Needs
Regardless of life cycle phase, allocate fixed amounts based on your needs and desires.
1. Determine what you want to maintain in emergency funds.
Funds that will cover 3-6 months fixed expenses.
If you have a solid asset base, then you probably own some lower volatility, higher liquidity, investments. Many people use these rather than pure cash for their emergency funds. Slightly more risk than cash, but also slightly higher returns.
2. Add in any money needed for planned short-term expenditures.
For Accumulators, this might be vehicles, wedding, children, debt repayment, etc. For Consolidators, a larger home, cabin at the lake, extra car, etc. For Spenders, vacations, known medical work, etc.
Cash for Unplanned Expenses
3. You might want to include a reserve for unplanned expenditures as well.
This may be especially prudent for Spenders. With no income other than savings and pensions, having cash available for unexpected costs (e.g., medical) may be wise.
But it may be a consideration for others as well. If personal circumstances dictate (e.g., health issues, young children, lack of medical or dental coverage at work, live in a location with violent weather, etc.) you may want to maintain a reserve for unplanned expenses.
Cash for Opportunities
4. Include a cash reserve for any investing opportunities that arise.
Always useful, but an area many people forget about.
It is nice to have free cash on hand should an interesting investment opportunity arise. Rather than not having the cash and missing out. Or having to sell another asset, incurring transaction costs and possible tax triggers, in order to invest in the new opportunity.
I suggest that this be an amount equal to what you may typically invest in any one asset. If you only invest $1000 at a time, that should be adequate. But if you normally invest in lumps of $20,000, your reserve will be higher.
Risk Tolerance and Personal Circumstances Affect Cash Allocations
How much you allocate to cash in each area will depend on your unique requirements.
If you work in a volatile industry with frequent layoffs, you may want to keep 6 months expenses in an emergency fund. If you work in a stable job, 3 months may suffice.
If you live in a hurricane belt, you might want to maintain some reserves for potential home damage and disruption of life.
How much you allocate will also be based on your personal risk tolerance.
The risk averse might want to save 6 months expenses regardless of how stable their employment is.
Aggressive individuals may want to keep little, if any, reserves for emergencies. Or the more aggressive may want to maintain their cash reserves in more risky cash assets such as foreign currency or short-term corporate paper.
The potential permutations are endless.
Once you total the above hard costs and factor in your risk tolerance, you will come up with the necessary cash component. Based on your total wealth, that will be the percentage that you need to allocate to cash equivalents.
As your circumstances change, while your needed hard costs may be the same, the percentage allocated to cash will shift.
In general, cash equivalents, including money market instruments, are low risk and low return investments. They are typically highly liquid and stable assets. For a little more detail, please review Cash & Cash Equivalents.
But as we have seen, within this asset class there are also high risk investments that may lack liquidity. Be careful.
Cash equivalents are useful for maintaining emergency funds.
Cash is a good investment for any short-term personal objectives (e.g., vehicles, housing, weddings).
Cash is also needed to cover short-term obligations in full, or as part of periodic payments (e.g., loan repayments with interest).
As short-term objectives and obligations approach, you can shift assets from less liquid and more volatile investments into liquid and stable cash assets. Do not wait too long to shift to cash. Otherwise, you may receive less than optimal value on disposition due to the asset’s liquidity and risk.
Finally, maintaining a portion of capital in liquid assets is useful to take advantage of sudden investment opportunities.
Cash for the Accumulator
Accumulators are typically young people starting out in life. Or individuals who have experienced a disruption in the normal cycle. Those who have been unemployed, out of the work force for personal reasons (e.g., injury, illness, raising a family), or new entrepreneurs.
In this phase of life, cash requirements may be high as individuals often accumulate 3-6 months emergency funds, begin families, and repay relatively high debt loads. All during a phase where income levels are relatively low.
There likely will not be much excess disposable income with which to invest for retirement. After liquidity allocations, what little one has to begin long-term investing probably should not be placed in cash equivalents.
This is because young investors have a long time horizon until retirement. They can prudently accept higher risk in their investments in order to pursue higher returns. Also, Accumulators will have a relatively high percentage of current wealth allocated to cash anyway. Money that is in emergency funds and available for short-term requirements.
As such, it is hard to estimate what young investors should maintain in cash. Many models suggest 5-25% of total assets in cash for investors with greater than 20 years until retirement. The lower end for aggressive investors, the higher end for conservative.
But perhaps you only have $30,000 in assets. Monthly expenses for rent, food, et al., are $2500 and you want to maintain 3 months of expenses in emergency funds. That equates to 25% in cash and does not even factor in any short-term objectives or payments due. Even if you want to be an aggressive investor, you may need a higher cash allocation until you attain a critical mass in your wealth.
For those who are extremely risk averse, 25% in cash might still be too aggressive for their personalities. They might want to have up to 100% of their assets in cash equivalents. Not what I would recommend for most investors developing a long-term investment strategy, but it might be appropriate for those with absolutely no risk tolerance.
As an aside, some investors maintain their emergency funds in investments other than cash equivalents. They accept some risk – potentially reduced liquidity and loss of capital – in order to generate higher potential returns. We are not talking venture capital. More like short term bond funds or even some lower risk equity funds.
Cash for the Consolidator
Typically, consolidators are individuals in the middle of their careers, probably in their mid 30s to late 40s or early 50s.
Income is relatively high and expenses are low. Personal wealth has increased and debt significantly reduced. There is excess cash available for serious investing.
Individuals should still maintain cash in an emergency fund. But given the level of savings already generated, it may not need to be 6 months worth. And, as a percentage of one’s overall allocation, it will probably be small.
In the example above, the person only had wealth of $30,000. So $7500 in emergency funds equalled 25% of total assets. But if the individual now has $300,000 in assets, a mere 5% allocated to cash for emergencies would be $15,000. Double what was put aside in the accumulation phase. If one maintains the same $7500 in reserves, the percentage allocated to cash falls to 2.5%.
As you can see, the percentage of assets allocated to cash must take into account both your potential hard dollar needs as well as your total wealth.
Consolidators may require additional cash for short term objectives. Buying a vacation property, taking a major vacation, paying for the education of children. Or even just generally upgrading one’s lifestyle with a larger home, better vehicle, and new wardrobe.
As this phase of life will see the bulk of one’s investing, it is also a good phase to maintain some free cash reserves to take advantage of opportunities that suddenly arise. Without available cash, an investor will either need to miss out on the investment or have to liquidate other assets to invest. In selling other assets, an investor will pay transaction fees. The investor may incur taxes on capital gains or face losses if forced to sell something prematurely.
Cash for the Spender
Spenders are those at or near retirement age.
Income will be low, but so too should be one’s fixed expenses. By now, people in the spending phase should have accumulated a relatively large amount of capital.
Because accumulated wealth is high, the percentage allocated to cash equivalents may be low. For example, with $2 million in assets, a reserve of 1% would still be $20,000.
But while mandatory expenses may be low, retirees usually want to enjoy life. With increased leisure activities (e.g., vacations, dining, entertainment), discretionary expenses may result in a desire for greater liquidity and ready cash.
While in their 30s, planning retirement needs, many forget about leisure. They factor in fixed costs, but do not include the increased discretionary spending that comes when retirees want to enjoy their free time. Without doing so, retirees may have enough money to live comfortably, but not enough to travel the world or engage in other more expensive pursuits.
Also, with little to no income, many individuals in the spending phase will have substantially less risk tolerance. They will want to allocate higher amounts to cash as protection in case of emergency (e.g., health issues, stock market crashes).
As you can see, your unique personal situation and risk tolerance will dictate what percentage of funds should be allocated to cash equivalents. And, as circumstances change, so too will your asset allocation percent and/or amounts.
In Part 2, we will summarize and look at the key points to focus on for your cash allocation calculation.
We began our review of the fixed income asset class with some key terms.
As for the asset class, it is common to group fixed income debt into three categories: money market, bonds, and debentures. Today we will look at money market instruments.
Money Market Instruments
I consider almost all money market instruments to be Cash Equivalents within one’s investment portfolio. But as they are technically debt, and are influenced by many of the same variables as other debt issues, I will cover them here.
Money market instruments are part of the short term debt market used primarily by governments and large capitalized corporations with very strong credit ratings. By short term, less than one year until maturity.
Most money market instruments are issued at a discount and mature at face value. No actual interest is paid by the issuer. Rather the difference between the purchase price and the value at maturity is considered the interest.
In every jurisdiction I can think of, the amount earned between the purchase price and face value is treated as interest income, not a capital gain, for tax purposes.
However, if the money market instrument is traded in the secondary market prior to maturity, a portion of the return may possibly be treated as a capital gain or even capital loss.
Government Treasury Bills
For short term borrowings up to 1 year in duration, governments issue treasury bills (T-bills).
No interest is paid on T-bills. They are issued at a discount to face value equal to the required interest rate. Upon maturity, the face value is paid to the investor and the difference between the discount and par value is treated as interest income.
Longer term bonds that do not pay interest, but are issued at deep discounts, are known as zero coupon bonds.
T-bills are guaranteed by the issuing government of a country. Because of the ongoing solvency of most countries, the shorter term T-bills are considered the safest of all investments. As such, the interest rate on T-bills is normally viewed as the risk-free rate of return.
Note that the fortunes of countries rise and fall. At any given time, a specific country’s T-bills may not be risk-free. For example, US T-bills are considered totally safe as I write this post. However, countries like Belarus, Greece, and Venezuela may not be seen as 100% secure right now.
Like any debt instrument, the interest rate offered by the issuer will depend on its credit rating. The worse the credit rating, the greater the interest rate that needs to be paid.
Corporate Money Market Instruments
Often corporations require short term funding to pay for current liabilities or finance short term assets such as trade receivables or inventory.
On average, corporations are riskier than governments. That should be intuitive. Though this can obviously differ on a case by case basis. For example, Apple may have a market capitalization that would equate it in the top tier of most national governments. Or the current credit rating of Venezuela is lower than many companies.
But being generally riskier than governments, you should expect to see corporate money market instruments paying higher interest rates than similar short term government debt.
When corporations issue debt for periods up to one year, they have a variety of options. Three typical ones, include:
Commercial Paper
Unsecured debt issued by a company. Because the debt is not secured against any corporate assets, only companies with very strong credit ratings issue commercial paper.
Depending on the credit-worthiness of the issuer, these notes may be more or less risky. Interest rates offered on commercial paper will fluctuate between corporations based on their relative risk.
Acceptance Paper
Also know as Finance Paper or Asset-Backed Commercial Paper.
Secured debt that is issued by a finance or acceptance company. The issue is secured by specified assets such as receivables or inventory.
Assuming that the security is adequate to cover the issue, secured debt is normally less risky than unsecured debt.
For example, Debtcorp issues two classes of paper. One secured against its trade receivables and inventory. The other unsecured. The non-secured debt will require a higher interest rate to be offered to reflect the higher risk of the paper.
Banker’s Acceptances (BAs)
Debt issued by a non-financial corporation but where a bank guarantees its repayment.
Of the three corporate options, the least risky for investors. This is because there are two layers of protection with the involvement of the bank guarantee.
Because it is the least risky, all other things equal, BAs will offer the lowest returns.
Investing in Money Market Instruments
Most individual investors never directly invest in money market instruments. That is because the required minimum purchases are too high for many investors.
However, individual investors do purchase these instruments indirectly through money market funds (MMF). As you develop your investment portfolio, I would expect you to have a portion of your assets in MMF. Likely for your emergency funds, cash set aside awaiting investment opportunities, cash available for near term financial obligations, and so on.
While each investor is unique, normally investing in MMF is preferable to holding your cash in savings or chequing accounts. That is because MMF offer higher returns than bank accounts, tend to be low risk, and are highly liquid.
Depending on the financial institution, they usually offer better returns and greater liquidity than term deposits and Guaranteed Investment Certificates.
I think the key takeaway with money market instruments, and any other fixed income offering, is the risk-return relationship. The more risky the debt instrument, the more incentive must be offered to entice investors. For short term money market instruments, this will be in higher interest rates offered for riskier debt.
But for longer term debt, it may be in securitization of the debt or priority of repayment. Or it may be in other sweeteners like conversion privileges into common shares. We will review various sweeteners in the near future.
The higher the risk of a debt offering, the less desirable it is for investors, and the greater interest and/or sweeteners required to attract investors.
You can also look at this from basic demand driven economics that applies to any asset (eg., your vehicle, house, art, gold). You decide to sell your home. If there is substantial demand for your house in the local market (hot market, great house, attractive area, little else for sale, etc.), you can ask more money. If you are selling your home in a down market with few potential buyers, you may need to list for less.
The same logic applies for all types of debt and equity issues. The more attractive an asset is to the investor, the less a company must do to raise capital. The less attractive the asset, the more a company must pay to attract capital. We will see this over and over and over again as we explore different investments.
We begin our look at asset classes today. I will not go too deeply into many of the assets themselves. There are plenty of good definitions on the internet. Rather, I want to look at the asset classes from an investing perspective.
How liquid are the assets? What are their risk and return profiles? What other factors impact their performance? How should you consider their suitability in your investment portfolio?
Today we will review Cash and Cash Equivalents (CCE).
Cash is king.
In life, all things material revolve around the almighty dollar. Without cash, you cannot purchase those things you need to survive. So this is an important asset class.
What is CCE?
As an asset class, CCE covers real cash, such as what you have in your savings or chequing accounts, or even hidden under your mattress.
It also includes other assets that possess these characteristics:
1. Extremely liquid,
2. Provide known rates of return, where investment risk is (almost) zero, and
3. Risk of capital loss is negligible.
Examples include: short term government treasury bills; short term government bonds; short term commercial paper, acceptance paper, or banker’s acceptances from highly rated companies; bank term deposits and Guaranteed Investment Certificates (GIC); money market funds.
As an aside, I am a little hesitant to label this category Cash and Cash Equivalents. Some experts include many marketable securities as cash equivalent. This is due to the high level of liquidity for certain fixed income and equities that trade on major exchanges. Also, that most individual investors lack the capacity to influence the asset price through their own holdings so can sell without impacting market value.
Where including fixed income or other assets in CCE breaks down is in the investment risk. Both in the expected returns and in the potential for capital loss. As we will see in due course, other asset classes all have higher risk levels that CCE.
Liquidity
Liquid assets can be quickly converted to cash; at minimal to no financial cost, nor impact on the asset price.
CCE are the most liquid of assets as they are already cash, or one small step from being cash.
Due to the liquidity benefit, you should have your emergency funds primarily in CCE. This should amount to between 3-6 months’ cash requirements. As your wealth increases, you can reduce the amount of liquidity held to some degree.
You should also invest in CCE with assets required for any short term spending requirements. The closer the time to the expenditure, the greater the need to keep the required funds in liquid assets.
For example, you plan to buy a house in 4 years. You can invest in a wide variety of assets, both liquid and illiquid. However, if you need to close the home purchase in only 4 months, you should have all the necessary funds invested in highly liquid investments.
Negligible Investment Risk
CCE are considered investments that have little, if any, investment risk.
That means the difference between the expected and actual rates of return is almost non-existent. There is no real volatility in the performance of this asset.
The Good News – Cash is Relatively Risk-Free
In investing, cash is considered certainty. With every other investment, there is some uncertainty that the amount you expect to receive in the future will be actually what you get.
If you recall our discussions on risk, the greater the uncertainty between what you expect to earn and what you actually earn is the risk (or volatility) of the investment.
With cash, there is no risk in the investment sense. What you have in your jeans is fully certain, assuming there are no holes in your pockets.
You know what you have and you can plan your spending accordingly.
Now there may be some investment risk with CCE, at least the CE portion of the term.
A GIC with a solid, national bank may have less risk than one with a small, regional institution which is having business difficulties. Although both GICs are considered cash equivalents, you need to look at the other risk factors also. We will look at this below.
The Bad News – Cash is Relatively Risk-Free
There is a direct relationship between risk and return.
The lower the risk of an investment, the lower the expected return.
So while CCE are risk-free to a great extent, the returns that you will earn will be low compared to other investments.
While this may protect you during the short term, when investing for long time horizons you should be considering higher risk assets, with better expected returns.
This is why many asset managers recommend only holding about 5-10% of one’s assets in CCE.
This amount typically covers the liquidity needs I mentioned above. It also serves as an investment reserve to allow for new purchases to be made without having to liquidate other non-cash assets.
Known Rates of Return
Time Value of Money
Knowing with certainty your actual return is useful when investing. When looking to the future, you can plan your investments to meet your upcoming cash requirements.
The higher the certainty, the better your planning can be.
You can invest that dollar today and receive more than that dollar tomorrow. Or next week or year. That is the basis for the time value of money principle.
In the case of CCE, your future return is almost certain.
For Example
You require $5150 for your school tuition and books in 6 months time. If you have $5000 now, you could invest in a 6 month Guaranteed Investment Certificate (GIC) from your bank paying 3% over the term. Upon maturity, you would receive your $5000 in capital, plus another $150 in interest income.
You have exactly enough to meet your requirements. Simple.
Now consider an investment in shares of a publicly traded company.
Over the 6 months, many variables could impact the share price. There is a possibility that the shares may be worth substantially more than the required $5150 in 6 months. But there is also a strong probability that the shares will be worth less than that amount. If the latter scenario occurs, you will not have enough money to fund your school needs.
For short term requirements, focus on liquid assets with minimal investment risk.
Beware of Non-Investment Risk Factors
While investment risk is negligible and nominal return is known, other factors can impact your real wealth accumulation.
Inflation
Inflation can erode the future purchasing power of your money by making goods more expensive over time.
In our example, you require $5150 for tuition and books. However, during the 6 months before you pay, inflation rises 4%. This equally affects your school requirements. Now your total costs have risen to $5356.
Had you not considered the potential impact of inflation, you would not have saved enough money for the required costs.
In our example, you would have invested in the GIC and ended up with $5150, but that would be $206 short.
A second takeaway concerning inflation is that it can reduce real wealth. In our example, you invested in a GIC. However, inflation outpaced the interest rate and your real wealth actually fell. As we discussed before, you need to always focus on real returns, not nominal ones.
Currency
If you live in a country whose currency is declining, you may also see an erosion of your cash value on a global scale.
Say you live in the US and want to buy a new BMW. Specifically one that is manufactured only in Germany. The car costs Euro 100,000 and the Euro/USD exchange rate is 1.00. Over the next 6 months you save your money and finally have USD 100,000 in the bank. You head down to the BMW dealer and go to place your order.
Unfortunately for you, while the price of the BMW is still Euro 100,000 that crazy US dollar has fallen to 0.80 against the Euro. In US dollars, your BMW now will cost you USD 125,000.
While liquidity and short term investing were not issues, you still suffered a shortfall due to the currency fluctuation.
Business
As I wrote above, GICs are issued by different financial institutions. Some are financially more stable than others. The same holds true for many other financial instruments.
When reviewing investment options, do not assume that a term deposit, commercial paper, or even government treasury bill is entirely risk-free. Always review the issuing entity and determine whether they are stable or not.
Would you consider debt issues of the US and Venezuelan governments to have the same risk?
One way to quickly assess business risk involves the returns being offered.
For example, banks A, B, and C issue 1 year GICs. A and B offer 5% annual interest rates. Bank C offers 7%.
Exactly the same product, so why the difference is rates?
Remember that risk and return are directly correlated. The higher the risk, the higher the return.
If I analyzed bank C, I would expect to see that there is higher risk of non-payment for the interest or original capital as compared with bank A or B. Because of the increased risk, bank C must offer higher rates than A or B to induce investors to take on the higher risk. If C offered only a 5% return, no rational investor would purchased a GIC from them.
Conversely, if C was as secure a bank as A or B, yet offered higher interest rates, no investors would purchase GICs from either A or B. Those banks would need to increase their interest rates to be competitive.
For additional general risks that may impact liquid assets, please review systematic risks.
For key areas of company specific risks, please check out non-systematic risks here and here.
So CCEs may be relatively risk-free from an investment and nominal return perspective. However, you definitely need to be aware of other risks that can affect your cash’s value and purchasing power.
Next we shall look at fixed income as an asset class.