We’ve all heard that cash is king – even in today’s world, where most merchants takes credit. But what about cash equivalents?
As their name suggests, cash equivalents are investment assets with a high level of liquidity. This means they can be turned into cash quickly without losing much of their value. In other words, they’re pretty royal in their own right.
You may not hear the term “cash equivalents” often in day-to-day life. You’re more likely to hear it in a boardroom or from your uncle who’s obsessed with the stock market. Still, it’s useful to understand cash equivalents because they can help bolster your investment portfolio in a low-risk way.
Here’s what you need to know.
What are cash equivalents?
Cash equivalents are pretty much what they sound like: investment assets that are equivalent, or nearly equivalent, to cash. They’re also considered liquid investments.
While there are many different types of cash equivalents, they all share some common defining features, like:
- Short-term maturity: Some types of investments, like CDs (certificates of deposit), have a set time in which your money grows. The date that term ends is called the “maturity date.” Cash equivalents generally mature in 90 days or less, which means you can convert the asset to cash quickly and without a loss in value.
- High liquidity: Cash equivalents are investment assets that are highly liquid, which means they have to be converted to cash whenever the investor chooses. So if the money you’ve invested is not readily available to be converted to cash – because you’ve invested, for instance, in a house or a painting – it’s not considered a cash equivalent.
- Low risk: Cash equivalents are supposed to be (roughly) equivalent to cash, whose value can change gradually over time – like with inflation. That’s why assets like stocks and mutual funds, which are prone to quick changes in value, don’t count.1
Cash equivalents are low-risk, easily accessible investments that can be quickly converted to cash. Money market accounts, treasury bills, bonds, and CDs all fit the bill.
How do cash equivalents work?
Companies count cash equivalents among their liquid assets to determine how their business is doing financially. The more cash and cash equivalents on hand, the more money is available to pay for debts, supplies, and services in the short term.
All that applies to individual consumers, like you, too.
Cash equivalents are a helpful option for people trying to save and grow their money without putting it at too much risk. They can also be an option for investors who want to cash in their investments at a moment’s notice.
For example, cash equivalents can bolster your emergency fund since the assets can be easily converted to cash when you need it. This strategy works best in tandem with a regular monthly savings plan. You should also keep enough money to cover your day-to-day living expenses in your checking account.
Types of cash equivalents
There are several different types of cash-equivalent assets you can invest in:
- Treasury bills and treasury bonds, also known as T-bills and T-bonds, are low-risk investment products backed by the U.S. government. The main difference between T-bills and T-bonds is how long it takes them to mature. T-bills mature in as little as four weeks and up to one year, while T-bonds have much longer terms, sometimes taking up to 30 years to fully mature.2, 3 Still, either can be easily sold before maturity, making it a cash equivalent.
- Certificates of deposit (CDs) are another type of low-risk investment vehicle offered by banks. Like T-bills and T-bonds, CDs provide growth at a fixed rate of interest over the course of a pre-set term. In many cases, CDs can be sold before they reach maturity, though you may pay a penalty to do so.
- Money market accounts are a type of bank account similar to your savings account. The most significant difference is that money market accounts tend to come with higher interest rates, which can help you grow your cash. You may also be able to access the funds with a debit card, which isn’t true of most savings accounts. Because of their growth potential, money market accounts can have higher minimum balance requirements than a traditional savings account does. However, like checkings and savings accounts, they’re usually FDIC-insured, so you don’t have to worry about losing a penny (up to the $250,000 maximum).4
Features of cash equivalents
Like cash itself, cash equivalents increase the amount of money you have available. They can also help you build out a diversified investment portfolio by providing some growth with relatively low risk. Here are the features of cash equivalents that make them attractive options for investors:
- They can be cashed out quickly. High liquidity means cash fast. We don’t have to tell you why that’s awesome.
- Unlikely to lose much value. Except for early withdrawal penalties, the money you put into CDs, money market accounts, T-bills, and T-bonds probably won’t significantly drop in value before you cash it out.
- There are plenty of options. Cash equivalents come in a variety of different shapes and sizes, so no matter where you are in your financial journey, chances are you can find one that works for you.
When to use a cash equivalent
Cash equivalents are a smart option for boosting your existing emergency fund or saving up for a short- to mid-term financial goal. If you’re planning to buy a new car in the next two years or saving for an overseas vacation, consider using cash equivalents.
Cash equivalents help you save and grow your money with relatively little risk and, in many cases, predictable returns. You can think of them as a slow and steady investment vehicle – they may not be the fastest option, but they’ll get you where you’re going.
On the road to financial security, cash equivalents are just one stop. If you’re focused on saving for your future, check out our beginner’s guide to investing.