Cash investments, also called cash equivalents, are short-term investments that earn interest, figured as a percentage of your principal.

One key difference between cash investments and other investments is their liquidity, which means they can be converted to cash quickly and easily with little or no loss of value. For example, if you invest $1,000 in a cash equivalent, you can expect to get $1,000 back, and perhaps some interest as well. If you invest $1,000 in stock, you might be able to sell your shares for more than $1,000, but you might also have to sell for less.

As part of your overall portfolio, cash investments can provide a buffer against fluctuations in the value of your more volatile assets, such as stocks. Keeping a limited amount of your portfolio in cash equivalents also lets you take advantage of new investment opportunities as they arise. And you can use cash investments as part of your emergency fund to cover unexpected expenses.

The money market

A money market isn't a place. It's trading in short-term liquid investments that goes on all the time among financial services companies and institutional investors.

Types of cash equivalents

While all cash equivalent investments are similar in providing liquidity and price stability, there are some important differences among the four major types of investments in this category: certificates of deposit (CDs), US Treasury bills (T-bills), bank money market accounts, and money market mutual funds.

Some cash equivalents, such as money market accounts and money market funds, offer greater liquidity — or access to your money — while others, such as CDs, offer less liquidity but may pay higher rates of interest.

And some cash investments are insured while others aren't. The advantage of insurance is that you can be confident that your money is safe. But the drawback is that insured accounts typically pay a lower rate of interest than uninsured accounts.

Some experts also consider short-term bond funds as cash equivalent investments since they are highly liquid and their value is fairly stable. But unlike any other cash equivalents, you can realize capital gains or capital losses when you sell these funds.

Certificates of deposit

Certificates of deposit (CDs), also known as time deposits, pay interest for a fixed term, usually at a fixed rate. The shortest CD term is usually three months and the longest is five years. In general, the longer the term is, the higher the rate the CD pays. That's to compensate you for tying up your money for a longer period. You can always withdraw money from a CD before its maturity date, but you may forfeit some or all of the interest you expected to earn.

Many CDs require a minimum deposit, sometimes $1,000 or more, but you generally must deposit at least $100,000 to get a higher rate for the same term.

Buying CDs

Most local and national banks issue CDs, although you can often get a higher interest rate from an online, or virtual, bank. Like all bank deposits, you may also be able to buy CDs from credit unions, where they're sometimes called share certificates. Most credit union share certificates are insured and may pay more interest than bank CDs.

Some brokerage firms sell CDs as well, usually slices of a large CD the firm has purchased from a bank. You may get a higher interest rate, based on the rate the underlying jumbo CD pays. And you don't have to hold your portion of the CD to maturity as the firm can always sell it to another client at market price, although you may receive less — or more — than you paid for it. The tradeoff is that you may have to pay a sales charge, or commission, which you don't pay when you buy a CD from the bank.

Callable CDs

Some CDs with long terms are callable, which means the bank can call, or redeem, the CD if interest rates drop. On predetermined dates throughout the term of the CD, the bank can decide to cancel your CD and give your money back, along with the interest you've earned as of the call date.

Banks and brokerage firms must tell you when you open the CD that it's callable, and they may pay a slightly higher interest rate for the right to call it. Your risk is that you will have to reinvest your money at a lower interest rate if your CD is called.

Variable rate CDs

While most CDs pay a fixed rate, some CDs pay variable rates, which means their interest rates change periodically during the term of the CD. Some variable rate CDs offer floating rates — meaning the changing rate is reset on a set schedule against the prime rate, a Treasury rate, or some other benchmark. Others offer a step rate that moves up or down over the life of the CD on a predetermined schedule.

US Treasurys

US Treasury bills (T-bills) are short-term government debt securities that are available in 4-, 13-, and 26-week terms. They're considered cash investments because of their short duration and their US government backing. In fact, they're sometimes described as risk-free investments, and serve as the standard against which the risk posed by other investments is measured.

The interest you earn on a T-bill is the difference between the discounted price you pay to buy, which is always less than the $1,000 face value, and the full face value, which is paid at maturity.

The US Treasury sells T-bills directly to both institutional and individual investors. To buy as an individual, you open a Treasury Direct account and have the purchase amount debited from a bank account you designate. When the bill matures, you can renew it or have its value deposited directly into the designated account. You can also buy and sell T-bills through a broker, though that would mean paying a commission on each transaction.

Money market investments

Money market accounts and money market funds, offered by banks and mutual funds respectively, resemble checking accounts in that they offer the highest degree of liquidity. For example, you can write checks against your account, withdraw cash, or have the money transferred between accounts the same business day.

But money market accounts and funds pay higher interest rates than interest-bearing checking accounts or regular savings accounts because they typically require higher minimum deposits.

Money market accounts are available at most local, national, and online banks. Most accounts have check-writing privileges, though there's often a limit on the number of checks you may write per month without incurring a fee. Each check may have to be written for a minimum amount set by the bank. And you may be charged a fee or lose some interest if your account balance falls below the bank's minimum.

Money market funds are available from most mutual fund companies, either as taxable or tax-free accounts. All money market funds make very short-term investments to maintain their value at $1 a share. Taxable funds buy various types of corporate and government debt, while tax-free funds buy municipal debt.

Most money market funds let investors write an unlimited number of checks against their accounts each month, though each check must be for a minimum amount — often $500. While you don't pay a sales charge to buy a money market fund, there may be a fee if your account value drops below a certain minimum.

With the exception of Treasury bills, which are exempt from state and local taxes, the interest you earn on cash equivalents is almost always taxable at your regular income tax rates unless you own the investment within a tax-deferred or tax-exempt retirement or education savings account.

Insured investments

Many cash investments offer the added security of government insurance. Bank money market accounts and time deposits, such as certificates of deposit, are both insured by the Federal Deposit Insurance Corporation (FDIC) to a limit of $250,000 per depositor per bank.

Most money market mutual funds, on the other hand, are not insured by the FDIC — although a few fund companies provide private insurance. US Treasury bills aren't insured either, but they are backed by the federal government, which can raise taxes to repay what it owes. In general, insured investments pay slightly less interest than uninsured investments.

FDIC coverage limits are $250,000 per depositor per bank for individual, joint, trust, and self-directed retirement accounts, such as IRAs, SEP IRAs, and Keogh plans. Depending on the number of accounts you have at your bank or banks, you may be covered for significantly more than the $250,000 limit.

Cash equivalents & fees

The fees and other penalties you may face are another factor in deciding how to diversify your cash portfolio.

Because certificates of deposit (CDs) are time deposits, there is usually a penalty for early withdrawal. In most cases, it means losing some or all of the interest that would have been paid on the account.

Penalties

There may be some ways to minimize the potential problem while still taking advantage of CDs. One solution is to ladder your CD investments, which means that instead of buying one large CD, you buy several smaller ones with different maturity dates. If you have CDs coming due every six months or every year, it may be easier to avoid withdrawing before maturity.

If you know you'll need your CD assets on a certain date, you may be able to arrange an individualized CD with an unusual term, say seven or nine months. That way, you don't lose any potential interest and you have the money when you need it.

You may also owe fees if your money market account or money market fund falls below the required minimum. If you have no choice but to use the money, it may be smarter to close the account entirely than to pay monthly fees that are likely to wipe out any interest earnings.

With US Treasury bills, you avoid sales charges by handling transactions through a Treasury Direct account. And if it seems likely you may need your money, you can stick to 4- or 13-week bills. Having to renew regularly takes a little more time, but it should prevent having to sell before maturity.

Interest vs. yield

The interest income you earn on cash investments may be calculated in two ways:

It may earn simple interest, which means the interest is figured on your principal alone

It may earn compound interest, which means that the interest you earn on the investment also earns interest

How the interest is calculated will affect the yield, or the rate of return on your investment. The more frequently the interest is compounded, the higher the yield.

Doing the math

For example, if you had $5,000 in an account that paid 5% annually in simple interest for five years, you'd earn $250 a year, for total interest of $1,250. In this case the interest rate and the yield are the same — 5% per year.

But the same $5,000 investment paying 5% compound interest for five years would produce a total of $1381.41 in interest. Because you're earning interest on your interest, the yield — 5.52% per year — is higher than the interest rate.

However, unless you're investing a large amount of money, it's probably not worth chasing after small differences in yield, since the costs of research and transferring your money may outweigh the nominal increase in earnings.

Market rate

The interest rates that banks pay on their CDs and money market accounts reflect the current market rate. That rate, in turn, is based on what's known as the federal funds rate, which is the rate banks charge each other to borrow money overnight. The Federal Reserve determines the federal funds rate as part of its effort to keep the US economy growing at a reasonable pace.

Your cash allocation

How much of your portfolio should you hold in cash equivalents? It depends on your goals and how long you have to meet them. If you have major expenses, such as college tuition, a down payment on a house, or retirement that you'll have to cover in the next two or three years, you'll want to keep a substantial amount of the money you've set aside for those costs in nonvolatile cash investments.

That's because your portfolio may not have time to recover from a potential market downturn, and you don't want to risk cashing out a substantial portion of your portfolio at a loss. Even so, you may still want to keep a limited percentage of your short- and medium-term investments in stocks or stock mutual funds for the potential growth they may provide.

On the other hand, if you tie up all of your long-term investments in cash equivalents you risk falling short of what you'll need to meet your future goals. That's because cash investments don't provide enough growth to outpace taxes and inflation over the long run.

Your next move

It can be smart to put a certain amount of cash aside — say 5% to 10% of your long-term portfolio — to take advantage of new investment opportunities you've researched, or so that you can invest the same amount on a regular schedule, say every month, or every quarter. But in general, you'll want to keep the majority of your long-term portfolio invested for growth, in stocks and higher-yielding bonds.

Rainy day fund

Regardless of how you allocate your investment portfolio, most experts agree that it's essential to keep a certain amount of cash on hand for emergencies. Most financial advisers encourage people to set aside three to six months' worth of income in a readily accessible, highly liquid account, such as a money market account or fund. You can tap into your rainy day fund when you have unforeseeable expenses, whether that's the cost of a new transmission for your car or emergency medical expenses for yourself or a member of your family.

Other experts recommend keeping a portion of your emergency fund in a balanced portfolio of stocks, bonds, and mutual funds, rather than solely in cash equivalents. They argue that you risk losing too much buying power to inflation if you have all of your emergency fund in cash equivalents. And they point out that you may be able to charge the costs to a credit card until a short-term investment matures or the market goes up. However, if you need all of the money on short notice, you might have to sell at a loss.

Investing vs. saving

Cash investments are an effective way of managing your money to meet short-term goals and to provide a safety net for emergency expenses. Because cash investments are considered low risk, they generally pay modest interest rates — usually not enough to offset the combined effects of inflation and taxes on your investment.

For example, if you put $10,000 in a money market account earning 4% interest, you'd accumulate $20,300 after 18 years. If inflation averaged 4% per year, your account would actually be worth $10,150. After taxes, you'd have considerably less buying power than when you started.

But if you'd invested the money in a portfolio of stocks earning an average of 8% for 18 years, you'd have $40,000. After accounting for inflation, you'd still have $20,000, or twice what you started with. Plus you'd pay taxes on your earnings at the lower long-term capital gains rate.

Preserving your principal

If you're so worried about the possibility of losing money that you put your money only into cash equivalents, you're investing to preserve your principal. Basically that means you get back what you put in, plus whatever modest amount of interest you earn.

While preservation of principal is an appropriate short-term strategy, as a long-term investment strategy it has serious risks. The double blow of taxes and inflation steadily erodes your real return, or the purchasing power of what you get back in relation to what you invest.

Inflation

The rate of inflation varies from year to year and rises and falls depending on several factors, including the economy and the strength of the US currency overseas. Since 1926, the inflation rate has averaged 3% annually. That includes the high point in 1980, when it hit 14%, and several years when it hovered around 1%.