This week we’re going to do something a bit different with the Investing 101 post. We’re not going use a question and answer format this week (Q and A, together: Awwww…). Instead, keeping with my lists of five theme, we’re going to look at five different investments that can fill the cash portion of your investment portfolio. We’ve covered stocks and bonds, now it’s time to complete the trifecta of basis investment categories.
All of these methods are relatively low risk, and have correspondingly low returns. They are used for stability in your portfolio, for specific saving goals and for emergency funds. They make a good anchor for your financial life, rather than an engine for growth.
There are numerous different types of low risk accounts, each with different roles in your financial life. Five popular ones include:
1) Checking Accounts – A basic type of account offered by banks and credit unions, which allow you easily transfer money into and out of the account. Frequently accompanied by a check book, allowing you to write paper checks against the balance.
Pro: It’s quick and easy to transfer money into and out of these accounts, whether by cash (as in, currency) deposits, printed checks, or automated fund transfers. Checking accounts are also federally insured up to $250,000, at least for the foreseeable future, so unless you are holding a large amount of money in your account, you don’t need to worry about bank failures.
Con: Checking accounts offer very low interest rates, if any. Money held in these accounts will generally not grow at all.
Best Used For: The ease of money transfer makes these funds ideal for paying bills or depositing checks; just don’t keep more money than you need to cover your outstanding bills in these accounts, as you’re giving up interest.
2) Savings Accounts – These accounts are used for, yes, savings. They offer the same protections as checking accounts, generally with higher interest rates. (Online-only banks will offer higher interest rates than those available from brick and mortar banks.)
Pro: These accounts offer the same protections as mentioned for checking accounts (up to $250,000 in protection for the amount in your account) and higher interest rates than checking accounts. Again, this holds especially true for online accounts.
Con: These accounts are less flexible than checking accounts, typically limiting how easy it is to withdraw funds from the account. They also have lower interest rates than CDs.
Best Used For: Savings accounts are great for general savings and building up an emergency fund.
3) Certificates of Deposit (CDs) – CDs are financial vehicles that lock up your money for set period of time, and give you a set rate of interest. In essence, they allow you to fix the interest rates that you earn on your money. CDs come in a variety of durations, with longer duration CDs offering greater interest rates.
They can be laddered, when a group of CDs is purchased with different maturation dates, allowing the invested money to be continually rolled over. If you have CDs that mature one, two and three months from now, you can wait one month, take the CD that will mature then, buy another three month CD, and again have CDs that expire one, two, and three months from now.
Pro: CDs usually (but, not always) offer higher interest rates than regular savings accounts. Also, they allow you to secure a set interest rate for the lifetime of the CD.
Con: CDs typically have some rather steep penalties (three to six months worth of interest) if you try to withdraw the money before the CD matures. Furthermore, because the interest rate for the CD is fixed, it’s possible that the interest rates for other accounts could rise, making the CD’s fixed rate less attractive. And, as with checking and savings accounts, the FDIC guarantees these accounts.
Best Used For: CDs are great vehicles when saving for a specific goal with a defined date, as they allow you to increase the interest you can get for your savings. A CD ladder also makes a decent way to build an emergency fund.
4) Money Market Funds – Money market funds are mutual funds that invest in ultrashort investments, such as commercial paper. These funds tend to be very safe and secure; only twice in history have any money market fund lost money.
Pro: Money Market Funds typically (but not always) offer higher interest rates than regular savings accounts. Since they are offered by mutual fund companies, it’s also easy to use money market funds as sources of funds to make automatic purchases of other mutual funds.
Con: Money Market Funds aren’t FDIC guaranteed, so there is the potential for money loss. (Although, as mentioned, this is very rare.) The interest rates on these funds also change much more frequently that the previously mentioned accounts, making it harder to determine exactly how much interest you will earn.
Best Used For: Money Market funds are great for holding money you’re going to invest in other mutual funds. If the interest rates are higher than what you can get from a high yield savings account, you can use them for emergency funds, as well.
5) Stable Value Funds – Stable value funds are basically funds that hold short or intermediate term bonds with insurance if the returns dip below a preset level. As a result, these funds can offer returns at or above those of money market mutual funds with virtually no risk.
Pro: Stable value funds can provide quite good returns. The insurance backing also makes their returns quite safe and secure.
Con: As with money market funds, stable value funds aren’t backed by the FDIC. Furthermore, it’s hard to invest in stable value funds outside of a company retirement plan, which makes them rather inconvenient for things like emergency funds.
Best Used For: If you want to add some cash to your retirement portfolio, investing in a stable value fund in your 401(k) is one good method.