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A Guide to Investing in Cash Alternatives

What is the role of cash in investing? Learn more about the role of cash in planning your finances, building a diversified portfolio, and pursuing investment goals.

Articles by Dan Egan

By Dan Egan
Managing Director of Behavioral Finance & Investing, Betterment  |  Published: November 10, 2014

In a diversified portfolio, a cash-like asset can help diversify risk for short-term investments.

However, over the long-term cash will lose real value due to inflation.

In a diversified portfolio, a cash-like asset, such as the ultra-low-risk bonds in Betterment’s recommended portfolio strategy can help diversify risk for your short-term investment goals.

However, over the long-term, cash will lose real value due to inflation.

Of course, you need to have a checking account with enough money for your regular cash flow, and then a little more for a sudden emergency. But any cash held in an average savings account, even though it might feel safe, may eventually hurt you because of inflation risk and low returns on your money.

That’s why we developed Smart Saver, which helps you manage your unused cash to mitigate inflation, using ultra-low risk funds. But other than that, we believe you can invest for everything else in your future—including your Safety Net fund.

In this article, we’ll explore the important role of an ultra-low-riskasset in a diversified portfolio. The most conservative assets in a Betterment portfolio are U.S. Short-Term Treasuries (iShares ETF, SHV) and U.S. Investment-Grade Bonds (iShares, NEAR). Together, our composite blend of these two assets behaves like cash in terms of ultra-low-risk, but the reward they generate in terms of yield is higher than cash.

We use SHV and NEAR to do three things:

  1. Reduce risk, especially with goals with a very short time horizon until their target date is reached (e.g., less than three years).
  2. Provide an option for investors who want to have a temporary, near-zero risk allocation for a portion of their investments.
  3. Serve as the the ultra-low-risk portfolio underlying Smart Saver.

What is Cash?

If you’re new to investing, there are a couple different ways to think about cash and investing. Cash has no volatility—it’s not invested in the market and its nominal value never changes. On one hand, that means it’s safe from market drawdown—but on the other, it never has any upside when the markets rise (historically, stock markets rise over the long term).

However, there are a couple of different ways it can be used for your money management and investing strategy.

Cash Savings Account: This is typically an account with a bank, and it currently has an average interest return of X.XX%. This account is liquid and is insured by the Federal Deposit Insurance Corporation (FDIC) when it’s in a bank account, but once it’s in your hand there is little you can do about material loss. (In other words, if you have money under your mattress or in a safe—once it’s gone, it’s gone.)

Best use for investors: Used in conjunction with a checking account, your savings account might contain a small amount of money to cover checking overages or other small emergencies, but pursuing a high yield is advisable and unused cash should not be kept here for a long period of time

Money Market Accounts (MMAs): MMAs generally have a slightly higher interest rate return than a cash savings account, but they also tend to have a higher minimum balance and fees and/or limits associated with accessing money. Restrictions on withdrawals make these slightly less liquid than a cash savings account. Don’t confuse MMAs with money market funds, which are invested and can potentially lose value. With an MMA, $1 is $1.

Best use for investors: MMAs are sometimes used as a short-term parking place for a large sum of money while it’s transitioning from one account to another. These are not advisable for growing wealth in real terms.

Ultra-Low-Risk Bond Portfolio: When we say ‘cash’ at Betterment, we’re referring to our optimized blend of U.S. Short-Term Treasury Bonds and U.S. Investment Grade Bonds.. These assets are attractive because they have an extremely low interest rate risk and low credit risk—which means near-zero volatility. That gives it a cash-like safety in a diversified portfolio.  It is slightly less liquid than a cash account in that it takes approximately four to five business days to withdraw invested money from a Betterment account.

Best use for investors: Available as  ETFs, short-term Treasuries and U.S Investment Grade Bonds can seamlessly provide a cash-like asset in a multi-asset portfolio. We suggest using Smart Saver, which has an optimal blend of ultra-low-risk bonds, for unused cash that you might be temporarily holding or unsure how to use. Read more about acceptable uses for Smart Saver.

Form of Cash Primary Risk
The cash in your wallet Inflation; material loss
The cash on your debit card or travelers’ checks Inflation; material loss
The cash in your savings account Inflation
Money market account Inflation, manager risk, credit and interest rate risk
Smart Saver’s portfolio Limited interest rate risk

How Does Cash Work in My Betterment Account?

In a Betterment account, we diversify your money across multiple asset classes. For investment goals with very short-term horizons (less than three years), we use the ultra-low-risk assets, SHV and NEAR to manage your risk. We automatically recommend increasing your portfolio’s exposure to these assets as your goal date gets closer and closer.

Allocation to Ultra-Low-Risk Bonds in the Betterment Portfolio Strategy

low-risk-bond allocation

You can learn more about how we optimize the Betterment Portfolio Strategy using cash alternatives in our methodology. While don’t generally recommend an allocation made up entirely of cash equivalents for an actual investment goal, we recognize it as an option for managing unused cash, which is why we offer Smart Saver.

If for any reason, you want to move some of your money to a low-risk investment portfolio, that option is available by changing your allocation to 0% stocks, 100% bonds, or by moving money into Smart Saver. To help you carefully consider that decision, our Tax Impact Preview feature can show you the tax consequences of selling equities to move to a more conservative allocation.

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