Cash equivalents are sage, highly liquid investment accounts that can be quickly converted to cash. Most earn a much smaller interest rate than traditional investments. Many investors use cash equivalents as a temporary "parking place" for their money while researching other, more lucrative investments.
The most common examples of cash equivalents are:
- Money Market Accounts (MMAs) are a type of savings account offered by banks and credit unions. Money market accounts typically pay higher interest rates than regular savings accounts, require a higher minimum balance (often greater than $1,000) and withdrawals are limited to as little as three per month.
- Treasury Bills (T-Bills) are short-term debt obligations issued by the U.S. Government with an average maturity of one year or less.
- Certificates of Deposits (CDs) are short to medium-term investments offered by banks. They generally have a higher interest rate than Money Market Accounts due to the longer commitment requirement. Money withdrawn prior to maturity is subject to a penalty.
- Money Market Mutual Funds are open-ended mutual funds, which invest in only money market accounts.
Money market accounts and CDs are insured by the FDIC, up to $100,000 per investor. Money market mutual funds are not FDIC insured but most have SPIC coverage, which is a private insurance program for mutual fund companies and brokerage firms. Because cash equivalents are insured, they tend to have considerably less investment risk than stocks or bonds.
However, one risk to consider when looking to invest in cash equivalents is simply inflation. If inflation occurs at a higher rate than what you are earning from your cash equivalents you will lose money and purchasing power. For example, if you only earn 2 percent interest from a cash equivalent account and inflation is 3 percent, your money is not keeping up with the rising cost of goods and services. Thus, a $100 cash equivalent investment will grow to $102 by the end of the year but a pair of shoes that costs $100 today will increase in price to $103 over the same time period.