Cash equivalents are any investment that can easily be turned into cash (without losing much, if any, in the conversion process due to fees, etc.) Any fixed-income investment that matures in less than one year is considered a cash equivalent. This can include Treasury bills, one-year (or less) certificates of deposit (CDs) or guaranteed investment contracts (GICs), and money market accounts or mutual funds.

Conventional investment wisdom states that you should generally have about ten percent of your portfolio in cash or cash equivalents, for the following four reasons: 1) you'll have a source of funds to handle any unforeseen occurrences. 2) You'll have funding for any imminent major purchases, such as a down payment for a home or college tuition. 3) You'll have funds to take advantage of an opportunity that may arise; for example, if the stock market falls you might want to have the cash readily available to buy into it. 4) It provides a measure of stability for your portfolio.

For retirement accounts such as a 401(k) plan, the first two reasons don't apply. You don't want to be tempted to pull money completely out of your retirement funding. The cash or equivalents available in your personal portfolio should be used for these occurrences. The two latter reasons are still valid, however. If the stock market sinks or interest rates begin rising quickly, you may want to tilt toward having less money in stocks or bonds; in this instance a money market fund might be more appropriate. Additionally, cash equivalents can also cushion an otherwise aggressive portfolio.

One big advantage of money market instruments is that they won't lose any money, even if the stock market dips or interest rates climb (which generally pushes the value of most bonds down). Money market instruments try to keep their share prices at exactly $1 at all times. They do this by investing strictly in short-term debt, debt that matures in, at most, an average of ninety days.

If interest rates were to rise suddenly, money market funds would generally catch up fairly quickly. The fund would lower the interest rate that it pays in order to keep its price per share level at $1. Then, as its existing debt instruments come due and are paid, the fund would buy newer, higher-paying debt and begin raising its interest rate.

The short-term debt that money market funds and accounts buy includes Treasury securities, bank CDs, and commercial paper (short-term lOUs generated by large corporations). The shorter the average maturities in a fund or account, the more quickly it can respond to rising interest rates.

If the safety of your money is of major concern, you should consider buying shares of a money market fund that concentrates on Treasuries that mature in an average of ninety days or less. These securities are backed by the full credit and faith of the federal government, which makes them extremely safe instruments. Money market funds may also invest in federal agency notes, which pay somewhat more than Treasuries.

 

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