Personal Finance Series Part 2: Understanding Cash and Demand Deposits – Blog Post 0004

"Spend each day trying to be a little wiser than you were when you woke up."
 - Charlie Munger

 

Financial Asset Classes

In the next several blogposts, I will outline various financial asset classes that the average person can invest in. You can think of asset classes as places where you can place/invest your money in order to preserve or grow its value/purchasing power. Real estate, stocks, bonds, collectibles and precious metals are some examples of financial asset classes. I will begin with simple assets and progress to more complex assets in future posts.

This blogpost will focus on cash and demand deposits, two asset classes where many people already have some money allocated. But before we begin, we need to discuss the concepts of inflation, deflation and tradeoffs.

Note: I strongly recommend that you read “Personal Finance Series Part 1: Assessing Your Financial Health” before continuing with this blogpost.


Inflation and Deflation

Simply put, inflation is your money losing its purchasing power over time. Today, a tomato costs $1.00 and in ten years a tomato costs $3.00. Deflation, is the opposite trend. Today your laptop costs $800 and in ten years you can buy the same laptop for $50.

Our financial system is inflationary by design. This means that the value of your money will decrease over time. The historical inflation rate for the US has been roughly 3.00% per year. This means that if today you have $100,000, in ten years you will need $134,392 to buy the same amount of stuff. So, $100K today = $134K in ten years. This is why it is important to invest your money!


Tradeoffs

All financial decisions are tradeoffs. Because most of us have a limited supply of money, we need to be prudent in the way we spend and allocate that money. If you go out for a fancy dinner tonight, you won't be able to afford a fancy dinner tomorrow. If you take a cruise in January you won't be able to go skiing in February. But more importantly, if you spend your money now, you won't be able to grow and have more money later from investing.

And now let's dive into Cash and Demand Deposits


Cash: The King of Asset Classes

Cash is the fundamental building block for all other financial asset classes and is itself an asset. Cash is a non-productive asset, meaning that it doesn't generate a return. In fact, keeping your money in cash will almost always guarantee you a loss in purchasing power over a longer timeframe. As a general rule, you can assume you will lose about 3.00% in purchasing power per year by allocating to cash (in the US).

Benefits of Cash

  1. Cash is THE MOST LIQUID ASSET. The liquidity of other assets is determined by estimating how quickly they can be converted to cash.
  2. Allows for anonymous transactions. If you don't want big brother tracking your every spending decision, cash is an ideal medium for transacting.
  3. Mobility. A stack of 1,000 x $100 bills ($100K) measures only 4.3 inches in height. If you need to flee an oppressive government regime, you can easily transport a substantial amount of money in the form of cash.
  4. Fungibility. A store owner doesn't discriminate between different bills. One twenty dollar bill won't be worth more or less than another twenty dollar bill.
  5. Widely accepted as legal tender for almost all goods and services (especially true of US dollars in developing countries)

Shortcomings of Cash

  1. Loss of purchasing power over time due to inflation. That $100 buys you a lot less in 2017 than it did in 1997.
  2. Cash can be misplaced, lost or stolen. There is no insurance for cash.
  3. The value of cash is subject to responsible actions and controls by central bank officials and other government officials. Google “Weimar, Germany Hyperinflation” for a quick history lesson.
  4. Associated with criminal activity. Because cash is the preferred transacting medium for many illegal activities, people that hold large quantities of cash are sometimes treated like criminals.

It is important to understand that your account balance in your checking and/or savings account is NOT cash. Cash is something you can hold in your hand.

A prudent individual always has some cash at their disposal in case of an emergency. I would recommend holding cash only from developed economies because those currencies are more stable and better maintain their value over time. The currencies that have been historically stable are: US Dollar, Euro, British Pound, Swiss Franc, Japanese Yen, Australian Dollar, New Zealand Dollar.


Demand Deposits: Money with Restrictions

Demand deposits are funds held in an account from which you can easily withdraw those funds and convert them to cash. Bank checking and savings accounts are examples of demand deposit accounts. In developed countries, the financial/banking infrastructure tends to be relatively stable and safe. This means that your demand deposits tend to be relatively safe as well. In the U.S., most demand deposit accounts are FDIC insured up to $250,000 (as of 2017).

Benefits of Demand Deposits

  1. Allows you to participate in online banking, which saves time and increases convenience.
  2. Allows you to automate payments for loans, credit cards and other expenses/bills.
  3. Allows you to earn interest on your deposits. Your money can grow from simply sitting in a demand deposit account.
  4. Provides a centralized ledger of your transactions which can be used to easily keep track of your finances.
  5. Allows for easy funding of other accounts, such as brokerage, CD, IRA, Roth IRA, and other demand deposit accounts.

Shortcomings of Demand Deposits

  1. Creates restrictions for converting back to cash. ATMs have a daily limit for withdrawals. Moving funds via online checking and savings accounts takes time and sometimes carries associated fees. Personal checks take time to clear before the funds are made available.
  2. Funds above $250,000 are not insured, although you can buy additional insurance.
  3. Demand deposits earn very low amounts of interest (currently 0.00-1.25%).
  4. Can make it difficult to access your money during a financial/banking crisis or political crisis.
  5. Have associated fees and charges.

It is important to have at least two demand deposit accounts: a checking account and a savings account. Currently, online savings accounts offer the best interest rates for your money and carry few restrictions for minimum daily balance and withdrawals (2017).


Conclusion

This concludes Part 2 of my Personal Finance Series. I want you to keep in mind that I am presenting these materials in a logical sequence. You should understand and master Part 1 before moving onto Part 2 or Part 3. You shouldn't invest if your financial health is poor. You shouldn't invest if you don't have an emergency cash fund. You shouldn't invest if you don't have a checking/savings account.

Most importantly, you should never invest in anything you don't understand. It is always a good idea to spend time learning about the risks and rewards of a potential investment or financial decision.

If you would like a personalized financial plan or financial education, feel free to contact me for more information.


Resources

This is a great site for evaluating demand deposit accounts, interest rates, CDs, etc: http://www.bankrate.com

This is a great site for financial definitions and tutorials: http://www.investopedia.com


DISCLAIMER: I am NOT a financial advisor and more importantly, I am NOT YOUR financial advisor. The materials/information presented in this blog are for informational purposes only. Decisions based on information contained on this site are the sole responsibility of the user, and in exchange for using this site, you agree that neither Boris Mozer nor his affiliates will be liable against any claims for damages arising from any decision you make based on such information.

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