Talking cash

Although short-term interest rates are at their lowest level in more than half a century, many individual investors continue to hold extremely high amounts of cash and cash-equivalent investments in their investment and savings portfolios.

In fact, the magnitude of household sector cash increased sharply from 1999 through 2003, even as short-term interest rates collapsed from the 6 percent range to less than 1 percent.

Household sector holdings of cash and other low-yielding short-term instruments increased from just over $4 trillion at the end of 2000 to over $5.5 trillion by the third quarter of 2003, even as the after-tax/after-inflation yield on the short end turned sharply negative.

So, why are so many investors holding on to cash and cash equivalents? The chief reasons cited tend to fall into the following categories:

• They are holding onto this cash until the "right" investment opportunity comes along.

• They have not yet focused sufficiently on the opportunity cost resulting from holding too much cash.

• They believe interest rates are currently "too low" and are willing to wait until yields on fixed-income instruments rise.

• They are convinced that if they invest in fixed-income instruments now, an "inevitable" rebound in yields will leave them with substantial losses on their current holdings.

What is an investor to do? The strategy I believe makes sense widely for investors, particularly in uncertain interest-rate environments, is a laddered strategy. A fixed-income portfolio is constructed to have the bonds mature over time, not all at once. This lessons the effect of declining interest rates because your money is "locked in" over time at higher rates. If interest rates increase, you have the opportunity to reinvest the proceeds elsewhere at higher interest rates.

Typically, each fixed-income position in the portfolio is the same size as the next and has a successively longer term to maturity. Each position is roughly an equal time interval between each maturity and is reinvested in the next higher "rung" in the ladder as each position matures.

In creating a ladder, the first thing I believe you will want to do is to choose an appropriate average term, which should coincide with the length of time that you need to receive income from the portfolio. Then, calculate the longest maturity, which should be about twice as long as the average term. Third, I like to determine the number of rungs, since the more the rungs used, the shorter the interval between each maturity date. And lastly, you must adhere to a consistent reinvestment rule.

For an investor with short-term investment horizons, a short-term laddered portfolio would be appropriate, with the longest maturity not exceeding five years. Consider these laddered strategies for other investment needs:

• An intermediate-term ladder in which the longest maturity is not longer than 10 years.

• Grow retirement accounts tax deferred with zero-coupon bonds, which could be structured to mature at or around the time when the income is needed for retirement.

• For education purposes, the principal is scheduled to mature in August of each school year to pay September tuition bills.

• A "check a month" portfolio can be constructed so that payment dates are staggered to pay monthly income.

Although a laddered portfolio is conservative, I have used this approach widely and successfully to minimize reinvestment and interest rate risks. For information, e-mail me at william.a.creekbaum@smithbarney.com or call me at 689-8704.

William Creekbaum, MBA, CFP, a Washoe Valley resident, is senior investment management consultant of SmithBarney, a financial services firm serving Northern Nevada.