It's time for investors to change how they think about cash.
The ultimate defensive asset, cash has always been the refuge from a storm in any market. For most of the past 15 years, though, cash has been trash—almost literally. It earned you nothing, and it dragged down the rest of your portfolio as just about every other asset soared. By keeping interest rates at or near zero, the Federal Reserve was all but ordering you to move your money out of cash.
This year, though, cash is far from trash , and it isn't just for defense anymore either. It's become an offensive weapon.
You can earn more than 5% on U.S. Treasury bills and on bank certificates of deposit. Although that return doesn't count inflation, it's high enough not only to protect you from a drop in other assets, but to be competitive with them.
No, this isn't market timing. I'm not suggesting you should dump all your stocks and put the proceeds in cash.
You should, however, recognize an obvious fact: Being able to earn 5%-plus with a government guarantee is an advantage investors haven't had since before the 2008-09 financial crisis.
When the risk-free rate is this high, you should think twice about taking risk.
With yields above 5%, every dollar of cash is "selling" for roughly 19 times what you can earn on it. U.S. stocks are also trading at about 19 times their earnings—but with no protection against loss.
In accounts earmarked for specific purposes that you plan to start spending down soon, keeping a bit more cash than usual can make sense now that you can earn 5% or more on it.
Some examples might be a college savings account for a child who's at least 17 years old, a pot of money you've set aside for an imminent down payment on a home, or a portion of your 401(k) if you're a year or two from retirement.
Likewise, if you've been wondering whether you should make a bet on distressed regional-bank stocks, why bother taking that risk?
Some regional banks whose shares have been battered by doubts are offering CDs paying generous yields to attract deposits and shore up their balance sheets, says Ken Tumin, founder of DepositAccounts.com and senior analyst at Lending Tree.
If you buy the stocks, you could lose most or all of your money. If you buy the CDs from the same banks, Uncle Sam protects you against loss through the Federal Deposit Insurance Corp.
One example: Pacific Western Bank's 13-month CD, which was offering a 5.5% annual yield this week. Treasury notes maturing around the same time yield 5.2%.
Most investors think of CDs as illiquid, since they lock up your money for a fixed period and there's no secondary market.
CDs often have an advantage many investors may not appreciate, though. If interest rates go down or stay put, you get to keep your CD. If rates go up, you may be able to redeem it, pay an early-withdrawal penalty and still come out ahead.
CDs effectively come with a put option, a contract in which you buy the right, but not the obligation, to sell an asset. So you ought to be able to withdraw early whenever the economics are in your favor. Heads, you win; tails, the bank loses.
"That provides a form of insurance to you, the depositor," says Allan Roth, a financial planner at Wealth Logic in Colorado Springs, Colo.
A hypothetical example: Say you put $100,000 in a 5% five-year CD today. Now let's say interest rates go up 1.5 percentage points next week. Your CD imposes an early-withdrawal penalty requiring you to forfeit six months' interest (or 2.5%). But now you can put the proceeds in a new, 6.5% five-year CD.
In making the switch, you pay the $2,500 penalty, but your remaining $97,500 will earn an extra 1.5 percentage points for the next five years. That's well in excess of $7,500.
This example assumes your early-withdrawal penalty isn't onerous. It's vital to check, in advance, that it won't be. Roth suggests a rule of thumb: If the extra interest you can earn for the remainder of the term is at least twice the penalty you'll pay, it's worth breaking the old CD.
The U.S. government stands behind the typical CD, with the FDIC insuring up to $250,000 per depositor against loss. (To figure out how to get much higher balances covered, consult the online calculator at edie.fdic.gov .)
Unlike on U.S. Treasurys, the interest on CDs isn't exempt from state and local income taxes. So, outside of a retirement account, you need to earn more on a CD to keep the same after-tax income you'd get on a Treasury.
Unless you live in a tax hell like California or New York, though, at today's yields you're likely to come out ahead in the CD, says Roth.
Right now, the sweet spot is CDs with maturities between one and five years. DepositAccounts.com and Bankrate.com are handy tools for finding the best rates.
For maturities under one year, Treasurys and money-market funds tend to offer higher returns than CDs, at least for the time being .
Even if you're the longest of long-term investors, every once in a while it pays to snap up short-term opportunities.