Interest rates are currently so low that it seems silly to put your cash in a savings account or CD. Savings accounts and short-term CDs pay almost no interest, and long-term CDs don't really justify keeping your money locked up for several years.
Source: Wikipedia.
The solution is to create a "ladder" with your cash holdings. This will allow you to earn some money while you wait to take advantage as rates begin to rise. Here's how to get started.
Why keep cash at all?
With interest rates so low, why would anyone want to keep cash at all? It's not a matter of accessibility. After all, as one of my readers (correctly) pointed out last time I wrote an article about cash, brokerage accounts have evolved to the point where you can sell investments and have your cash within a day or two.
However, there are two main reasons you should keep some cash. The first is for emergencies. Sure, you can quickly pull money out of a brokerage account, but you should have emergency cash that doesn't fluctuate. What if you have an emergency during a market crash? You may have to sell a lot of stocks at the bottom of the market to cover your expenses. The whole point of investing is to not have to touch your holdings for a long time, and especially not to sell off great companies at a loss.
The other reason is to be able to take advantage of investment opportunities as they come up. Let's say a stock you've been considering drops by 10%, and you're finally ready to jump in. Well, if your money is 100% invested, you'll have to sell something else to buy shares. If you have some cash waiting on the sidelines, this becomes much easier.
How to start and maintain a "ladder"
The basic concept behind an investment ladder is to stagger your fixed-return investments (bonds, CDs, etc.) so you take advantage of the higher-paying long-term rates while still being able to take advantage of rising interest rates in the near future.
The best place to put your cash (interest-wise) is in CDs. So, divide your money in fifths. Take one-fifth of your cash and buy one-year CDs, then put one-fifth into two-year CDs, three-year CDs, and so on. Basically, one-fifth of your CDs will mature each year, and when they do, you simply roll it into CDs that expire five years in the future.
Why is this important? As of this writing, the best rate you can hope to get for a five-year CD is about 2.25% APR. However, if you put all of your money into five-year CDs, and the market rate shoots up to say, 4% next year, you'll be out of luck. This way, you'll have some of your CDs coming due next year, and you can take advantage of the rising interest rates that are expected over the next few years.
If you do need your money in a pinch, the early withdrawal fees vary from bank to bank but are usually just a couple of months of interest. So, if you have an actual emergency and need your cash, your money isn't exactly tied up for five more years.
It works for bonds also
This concept of a ladder works well with bonds also. If you keep a substantial amount of your portfolio in fixed-income securities, it is incredibly important to stagger the maturity dates, especially with interest rates being as low as they are.
If you buy bonds that don't mature for 30 years, you'll get a decent return by today's standards, but as rates rise, the value of your bonds will drop significantly. And, if you put all of your money into short-term bonds (expiring in a year or so), your returns are likely to be so low that you might as well just buy CDs. Creating a bond ladder gives you the best of both worlds -- present-day returns and the opportunity to capitalize as rates rise.
You need some cash, so why not get paid for it?
Sure, even when rates rise, the returns you get from your cash accounts will be pretty low compared to what you could achieve with stocks, or even bonds.
Still, it's better to get something from your money rather than nothing, and you might be surprised how much of a difference those small returns can make over time. If nothing else, this strategy can help your emergency fund keep up with inflation, and they can produce a little extra cash to invest from the money you're keeping on the sidelines.
