More Than a Rainy-Day Fund

There's an unwritten rule in investing. When times are good, stick with stocks. When times are bad, bet on bonds. And when times are uncertain, dash to cash.

This advice certainly paid off for investors last year, as cash wasn't just a defensive play--it turned out to be a relatively strong asset class.

Thanks to rising short-term interest rates, three-month treasury bills produced returns of around 3.2 percent in 2005. By comparison, the Lehman Brothers Aggregate Bond index was up 2.4 percent. And the Dow Jones industrial average was up less than 2 percent.

Perhaps the most remarkable development: Cash investments in 2005 outperformed Pimco Total Return, the most respected bond fund in the country.

Many think cash will continue to shine. "We definitely expect a big year next year," says Peter Crane, managing editor of iMoneyNet.com, which tracks money market fund rates.

Rising rates. There are several reasons. First and foremost: The Federal Reserve is not done raising short-term interest rates. Last year, the Fed hiked rates from 2.25 percent to 4.25 percent. That, in turn, sent money market yields soaring 2 full percentage points--from around 1.6 percent to 3.6 percent. The consensus on Wall Street is that the Fed will hike rates at least one more time--and possibly two. That would easily send money fund yields above 4 percent. If the Fed raises rates even higher, cash would do even better.

There's another reason to be bullish on cash. Market strategists predict a relatively modest year for investment returns among all the other major asset classes--stocks, bonds, and real estate. Consider that the average money market fund is already generating modest single-digit returns. Some one-year CD s, in fact, are paying out 4.5 percent or more--which is more than what 10-year treasury notes are yielding. "Cash is becoming a pretty formidable competitor to these other assets," says Jeffrey Knight, chief investment officer for global asset allocation at Putnam Investments.

But while cash will continue to do well for a while, investors need to be careful. Should the economy begin to stall, the Fed could do an about-face and start trimming interest rates late in 2006--which would be a boon for stocks and bonds but hurt cash.

Investors also need to do some homework. Greg McBride, senior financial analyst for Bankrate.com, notes that "it really pays to look beyond your local bank." He points out that while the average one-year CD is paying out a little more than 4 percent, the highest-yielding one is paying out around 4.8 percent. Similarly, while the average money market deposit account at a bank still pays out less than 2 percent, you can find some banks paying more than 4 percent.

Speaking of money market accounts, investors who are looking for a very liquid cash vehicle--one that doesn't lock in your money for a set period of time, as CD s do--might want to consider money market mutual funds. If the Fed continues to raise rates, Crane says, money funds are likely to outshine other traditional cash accounts since they invest directly in short-term securities whose rates are affected by the Fed. On the other hand, banks help set the interest rates on their money market deposit accounts. And not all banks are quick to increase their payouts when the Fed is hiking rates. -Paul J. Lim