OK, CASH MANAGEMENT doesn’t exactly match the adrenaline high of trading stocks. But managing your cash holdings is a challenging discipline, and a prudent and profitable way to get market experience with considerably less risk. It’s also a lot of fun — especially for less-capitalized traders who can’t afford to play in the majors just yet.
For many of us, cash comes in the form of a money-market account, usually either linked to a brokerage account, bought from a mutual-fund company or sold by a bank. Only bank-sold money-market funds come with FDIC insurance, but all suit the same general investment goals: safety and high liquidity. They are essentially savings accounts — and they’re more for peace of mind than for profit. The problem with money-market accounts is that, in exchange for liquidity and protection of principle, we forfeit the higher returns that come along with even slightly more risky investments. For example, E*Trade Group’s (ET) money fund currently yields 3.7%. Fidelity’s is in the high 2% range. Not exactly champagne wishes and caviar dreams.
But with sound cash management, you can do better. You manage a cash portfolio just as you do a stock portfolio. Using appropriate position size, money management and risk controls, you can improve results with only marginally higher levels of risk.
As I wrote last week, traders have a tendency to suffer from “all or none” thinking. Either they’ve got 100% of their money in Cisco Systems (CSCO), or all of it stuffed under the mattress. But you can shoulder more risk without being reckless. You’ve got a money-market fund, and that’s great. Now spice it up. Throw in some emerging market debt or closed-end junk. From riskier bonds to longer dated certificates of deposit, there’s an opportunity to diversify.
Compared to the hallucinogenic returns of years gone by, squeezing a few extra tenths of a percentage point out of your cash might not seem that significant from month to month. But over time, it can really add up. Let’s assume you’ve got $10,000 set aside for long-term, low-risk savings. Over a 25-year period, the difference between a 3% compounded annual return and a 4% annual return is staggering. If you earn just 3%, you’ll end up with $20,937, but 4% garners $26,658. Average 4.5% over that same period, and you’ll bank $30,054. That’s 83% more return on “just” 1.5% extra juice each year.
This is what’s really behind the “long-haul” rhetoric that we so often hear as a reason for owning stocks. The power lies in the mathematical effects of compound interest, not in equities as an asset class. Even low levels of investment return make money grow exponentially when allowed to consistently compound over time. No wonder Ben Franklin called compounding “the eighth wonder of the world.”
One lay-up in the search for higher yields is certificates of deposit — which, depending on the term, are now paying significantly more than money-market funds. Bought through a bank, CDs offer FDIC insurance, no commissions or brokerage fees, and pay a fixed rate of comparatively high interest. For example, as of early July, the top one-year CDs are paying 5%. Longer-dated maturities pay even more.
The hook with CDs, of course, is that there is no liquidity. Certificates of deposit come in maturities ranging from one month to five years or more — but in exchange for higher interest, you give up the right to get to your money. Unless you pay a hefty early-withdrawal penalty, CDs are essentially “locked” until they mature. Personally, when it comes to saving money, I find the “no withdrawal” policy more of a help than a hindrance: It’s harder for me to spend money when I can’t get at it.
Like money-market funds and CDs, the other instruments you’ll use for cash management are all debt of one form or another. So in managing your cash, you are really a bond trader, and while stocks get all the glory, the biggest and most important market in the world is the bond market.
In this market, “buy low, sell high” is reversed: The idea is to lock in high rates before they go lower and avoid getting stuck in low rates as they go higher. A year ago, for example, the yield on the benchmark 10-year government bond was 6%. Now the same bond pays in the low 5% range. There are dozens of high-quality bond funds that can boost your overall return. The main consideration here is duration. Long-term bonds are more sensitive to changes in interest rates, and if rates spike, these funds will tank. So despite their “safe” image, it’s possible to lose money investing in a bond fund.
And some bond funds are clearly riskier — and potentially more rewarding — than others. Emerging-market bonds funds are poised to become the sleeper hit of the year. They are up 8% year-to-date, 5% in the second quarter alone. Despite some volatility, high-yield or “junk” funds are also hanging in. The low cost Vanguard High Yield Corporate fund (VWEHX) is up a respectable 2% year-to-date. Convertible bond funds are outperforming, too. But remember: These are much riskier propositions than money-market funds or CDs. Like extremely strong seasonings, they should be used judiciously to spice up your cash portfolio.
So there’s more to “cash” than a money-market fund. So pick a benchmark — say the Lehman Brothers Aggregate Bond Index — and see if you can beat it. Allocate 5% here, 10% here. Keep more cash than you need on hand. Don’t aim for home runs, but consistent singles. Risk, not recklessness.
– Originally on Jul 05, 2001 by Jonathan Hoenig
