Part 2:
Basic Tools of Personal Finance

Four classes of assets form the majority of most investment portfolios:

• cash and cash equivalents,
• bonds,
• stocks, and
• tangible assets (e.g., real estate, gold, oil).

Cash denotes your current stash of legal tender and, in a financial planning context, generally includes money deposited with financial institutions that can be withdrawn without notice. Checking and passbook savings accounts are examples of such deposits.

Cash equivalents are defined as short-term investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value. Such investments are often referred to as "liquid."

Liquidity refers to how quickly an asset can be converted into cash. Your house is not a liquid asset because it could take months to sell it. Stocks are somewhat more liquid than real estate, but you can lose money on stocks if you're forced to sell at a time when the market for your stock is less than favorable. Even though interest on liquid investments may barely keep up with inflation, the lower risk is worth the lower return when you may need the money quickly.

Deborah Fowles suggests that checking accounts, saving accounts, money market accounts, certificates of deposit, money market funds, and short-term bonds are all good places to stash the cash you may need on short notice. These are the most liquid investments.

Checking accounts pay infamously low interest and may come with monthly service charges, so these are not the first choice for emergency funds. Another reason to avoid mingling your emergency fund with your regular checking account is that money in your checking account is too easily spent.

Savings accounts usually pay somewhat higher interest and segregate your savings from the money that covers your living expenses. They're less likely to have monthly fees.

Money market accounts offered by banks (not to be confused with money market funds) may pay a little higher interest than either checking or savings accounts but limit the number of transactions you can make without a fee.

Money market funds, offered by brokerage houses and mutual fund companies, are NOT FDIC-insured like money market accounts are, so they're not as safe.

Certificates of Deposit (CDs) are funds you lend to the bank for a specific period of time in return for a guaranteed, pre-determined interest rate. They come in different maturities, such as three months, six months, one year, five years, etc., and cashing them in early will result in a penalty, so they are not quite as liquid as the other investments mentioned. However, if you ladder your CDs you can avoid this problem.

We have four lessons to help you in making decisions related to the short-term cash and equivalents portion of your portfolio:

1. TPF-1 Checking Accounts
2. TPF-2 Credit Cards
3. TPF-3 Bank Products and Insurance
4. TPF-4 Prepaid Phone Cards

Continue to Part 3 >>> Long-Term Loans >>>
 

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