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Saturday, June 16, 2012

Too Much Cash?

Yesterday I touched on the cash/emergency fund position held by many people and what they are sacrificing - basically the opportunity cost of holding cash equivalents in today's low-yield environment. This is an area that, in my experience, can fairly easily produce extra oomph to the portfolio.  And it is something to focus on with an advisor if you can't do it yourself.  Many times intelligent moves in this portion of the assets alone will more than pay for the advisor's overall services.

To review - most people usually hold more in cash equivalents like money market funds, Treasury bills, and certificates of deposit (CDs) than they should.  Some say it is for emergencies.  Some say it is to avoid risk.  Others also say it is because they haven't decided where to put it.  Actually, I gently remind the indecisive they have decided - it is in money markets, etc.  This is an area where avoiding making a decision is actually making a decision.

An important point in yesterday's post was that holding cash equivalents doesn't avoid risk; it substitutes purchasing power and re-investment risk for market and/or credit risk.


So how can the cash position be reduced and yield increased with an eye on market risk?  Keep in mind that we are focusing on short-term investments and not the broader fixed income portion of assets.

As a specific example, assume that you hold $20,000 in money markets, etc. and decide that $5,000 is sufficient for an emergency fund.  You seek to increase the yield on the additional $15,000/year by 2% and at the same time avoid market risk.  This would bring in an extra $300/year.  What is one way to do this?

The first point to be clear about is that moving from Treasury bills and CDs entails taking on credit risk. This is the fundamental risk-reward relationship.  The second point is that, to lessen market risk, we are seeking fixed income investments that have a short duration.  If you are willing to look past the market value of the investment and just look at cost (because you will hold it to maturity), you may be able to ignore price fluctuations.

With these caveats in mind, let's begin by looking at specific bonds.  If we go into Schwab's bond offerings (easy to do online and for most discount brokers) and putter around a bit, we find the following offerings:

Source: Charles Schwab
The yields-to-maturity are shown in the right hand column.  The Goldman Sachs issue yields 3.484% and matures in 3.5 years.  That's a 2.2% after tax yield for those in the 25% tax bracket.  Obviously these issues are a bit risky - the orange down arrow indicates they are in line for a possible downgrade. Still, they are most likely to retain investment grade status over the period even if they are downgraded . Not to be glossed over is the fact that the higher echelons of our Federal Government are generously populated by one-time Goldman Sachs partners/managing directors.

The J.P. Morgan piece is also interesting.  I would watch it to see if the yield doesn't become more attractive.  Maybe wait to see if it is downgraded and then pounce.  After all, how many businesses can lose $2 billion, treat it as a minor issue, and tell their shareholders they will be profitable in the upcoming quarter?

A different route to take with short-term funds would be to use exchange traded funds (ETFs).  One idea is short-duration corporate funds, such as PIMCO's new high yield fund HYS.  It has an expense ratio of 0.55%, expected yield in the neighborhood of 6%, and is an index fund managed by the biggest bond manager in the world.  Again, I would limit exposure to 5% of total assets.  Another idea, less risky and hence lower yielding, is Vanguard's short-term corporate ETF, VCSH.  The trailing 12-month yield is 2.28% and the expense ratio is .15%.

The bottom line is that there is a lot out there for DIYers who aren't lazy and are willing to take on a bit of risk in order to increase yield.

Disclosure:  This post is for educational purposes only.  Individuals should consult a professional or do their own research before making investment decisions.

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