Thursday, March 25, 2010

Where you should (and shouldn't) keep your cash

(Money Magazine) -- Question: My wife and I have $25,000 in a money market account earning almost nothing in interest. We would like to place $20,000 in some kind of an account that will give us a better return. This is our emergency money, so we'd like to invest it in something fairly safe. We also need to be able access the funds if necessary. I've had suggestions to invest in bonds, CDs and another money market account. Do you have any suggestions or recommendations? --Ted Graham, Grandville, MIchigan

Answer: Any time interest rates fall anywhere close to the levels we're seeing today, you can be sure that many people will be looking for some way to grab a higher yield without sacrificing safety.


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And you can also be sure that there are going to be any number of seemingly secure investments to cater to that desire.

Unfortunately, higher returns don't come without higher risk. Risk and return go together, kind of like politicians and spending.

Which is what investors found outwhen investments such as auction rate preferred securities and bank loan funds -- which had been promoted as alternatives to money-market funds -- imploded in 2008.

Some things never change.

Today, with interest rates on money funds scraping along below 1% and yields on short-term CDs not much higher, income-hungry investors are still eager to find higher yields -- and many advisers and financial firms are just as eager to oblige.

But make no mistake -- stretching for yield means taking on more risk.

Sometimes, that risk may result from the way the investment is designed. Take reverse convertible notes, which are securities with payouts tied to the value of a particular stock. Earlier this year these securities -- sometimes referred to as "revertible notes" -- were touting coupon rates of 10% or more.

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What some investors drawn to that figure may not understand, however, is that if the price of the underlying stock dives, the return can plummet, possibly even leading to a loss of principal. For this and other reasons, FINRA, the Financial Industry Regulatory Authority, recently issued an Investor Alert about reverse convertibles.

In other cases, the creditworthiness of the company offering the higher-yielding investment may be a concern. For example, an ad that has recently appeared in the business section of The New York Times touts "High Interest Rate Deposits." The copy goes on to read: "6% return instead of 1.5%. It just makes good sense!"

That's not the conclusion I came to when, after calling the phone number in the ad, I found that this wasn't a bank deposit, but what was described to me as "an equity voucher." As far as I could tell, that means you're buying unsecured debt issued by a company that the representative said had been in business "about a year."

My already faltering confidence crumbled more when I discovered that the person who assured me over the phone that I would get a guaranteed 6% return had in July signed a consent order with the U.S. Commodity Futures Trading Commission essentially barring him from the commodities biz and requiring him to pay $10,000 in restitution and a $30,000 penalty for, among other things, telling "customers that they could earn large profits trading in commodity options while failing to disclose adequately the risk of loss inherent" in that activity.

The lesson here is that if you're reaching for more yield, then one way or another, you're accepting more risk. There's just no way you're going to find an investment that offers the same security of principal as money funds, money-market accounts, savings account and short-term CDs with significantly higher yields than those vehicles.

Yes, you could move some of your money into a bond fund for a shot at a higher payout. But the value of your fund will take a hit if interest rates rise. The longer the maturity of the bond fund -- and the bigger the rise in interest rates -- the bigger the hit.

So my suggestion is if this $25,000 is really your emergency money and you want to have ready access to it and you don't want to put your principal at risk, then stick to secure investments like high-quality money funds,short-term CDs and true FDIC-insured bank deposits.

Granted, they're all paying paltry returns right now. But at least you can rest easy knowing that your money will be there when you need it. And that's the point of having an emergency fund anyway, isn't it? To top of page

By: Money Magazine: Ask the Expert