The word “cash” is often assumed to mean bills and coins. In the financial planning world, cash includes bills and coins plus the contents of a number of other financial accounts, which include: money in checking and savings accounts, certificates of deposit (CDs), Treasury securities issued by the federal government, as well as funds in some money market accounts. Collectively, these holdings are sometimes referred to as cash equivalent instruments. We’ll discuss these momentarily, but first we’ll introduce the concept of liquidity.
A liquid asset can be quickly converted into cash with minimal or no loss in value. Liquidity risk refers to the probability that you will suffer a loss by having to sell an asset at a steep discount when you have an urgent need for cash.
Generally, we demand a higher interest rate for less liquid assets. This higher rate compensates us for liquidity risk. The greater the illiquidity of an asset, the greater the reward we demand for accepting that lack of liquidity. Conversely, a more liquid asset will yield you a lower rate of return. This conforms with the general financial principle that if you want low risk you must accept a low return, while seeking high returns necessarily exposes you to higher risk.
Cash Equivalent Instruments
Let’s review some cash equivalent instruments, sorted from most to least liquid.
Funds in your checking account are highly liquid. You can access them almost instantaneously. You can go to any ATM and pull out a few hundred dollars. You can go to your bank branch counter and withdraw money immediately. You can also link your Paypal account to your checking account and instantly fund online purchases or transfers. The downside to this convenience is that you receive zero interest on holdings in a checking account.
Savings accounts typically offer some interest, but rates are low. Banks may offer premium savings accounts with higher rates, but to qualify for these higher rates, you may have to meet fairly high minimum balance requirements across your bank holdings, for example, on the order of around $50,000.
You can withdraw money fairly quickly from savings accounts. But there’s a difference between savings and checking. You can demand money from your checking account at any time and the bank is obligated to provide it to you. The technical term for checking accounts is “demand deposits.” In contrast, a bank can choose to make you wait anywhere from a couple of days to a month before giving you money from your savings account.
Banks have no reason to alienate their clients, so they usually allow you to make savings account transactions quickly and seamlessly. But technically the bank is within its rights to delay withdrawals from savings accounts.
Money in a certificate of deposit (CD) can be accessed quickly, but there may be a redemption penalty equal to some percentage of the interest you already earned on the CD. This makes consumers slightly reluctant to sell CDs prematurely, making CDs slightly less liquid. But we can still consider them to be cash equivalents since they can be redeemed on short notice with relatively minor interest penalties.
Money market accounts are similar to savings accounts. They may allow some limited check-writing and offer higher interest rates but require you to maintain deposit minimums or face monthly fees. Those fees make depositors somewhat reluctant to reduce balances below thresholds, which translates into slightly lower liquidity.
Early withdrawal penalties and fees for low balances make some cash equivalent instruments slightly illiquid. But other financial assets have much more extreme liquidity characteristics. For example, real estate is on the other end of the liquidity spectrum. We could say that real estate is illiquid. It may take months to sell real estate, and if you must sell quickly, you can only do so by reducing the price dramatically, undermining the asset’s value.
An advantage of checking, savings, CDs, and money market accounts offered by banks is that they may qualify for Federal Deposit Insurance Corporation (FDIC) protection of up to $250,000. If the issuing bank fails, the FDIC compensates consumers. In contrast, investments in stocks and bonds don’t receive FDIC protection.