You don't need a Ph.D. in mathematics to understand that the numbers aren't working in your favor these days. The Fed's aggressive easing of the federal funds rate has made a mess of your cash and fixed-income strategies.
The most aggressive bank savings deals pay out little more than 2.5 percent to 3 percent right now. Given that the official inflation rate is around 4 percent, you're pretty much guaranteed a negative real rate of return.
I'm hearing from more and more of you that you're shifting from CDs into 10-year Treasuries, where the yield is about double what your bank might be paying out. Please be careful when extending into longer maturities - you're exposing yourself to locking in a low rate of return. Given the inflation rate, that's a bad place to be once the tide turns and the Fed starts to tighten.
Now is the time to cautiously navigate the world of fixed income.
The point of your emergency cash fund is to protect you. The need for safety outweighs the desire to earn more in riskier investments. Your eight-month emergency cash fund belongs in, well, cash. You don't put this money at principal risk. Earning the highest possible "safe" return means shopping for the best bank deal.
Currently, I would own a mix of short- and medium-term-maturity bonds to best address the risk/reward challenge for the fixed-income portion of your portfolio. If inflation is a concern, consider Treasury Inflation-Protected Securities instead of straight Treasuries. The interest rate is fixed on TIPS, but your principal is adjusted every six months in line with changes in the Consumer Price Index.
Credit-crunch fears have created an investing opportunity in tax-exempt bonds. If you stick with highly rated bonds, the risk remains quite low and the yield can't be beat. The average yield for five-year AAA municipal bonds was recently 3.1 percent. That's more than the 2.9 percent payout on a regular five-year Treasury. And Treasury income is taxed at the federal level, while municipals, of course, are tax-free. If you're also subject to state and local income tax, municipals look even better.
Many of you are so focused on how to wring out an extra half-percentage point on your cash and fixed income that you're overlooking the potential for risk-free returns lurking on the debit side of your financial statement.
Once you have your eight-month to one-year cushion, don't unnecessarily hoard more dollars. In this low-rate environment, it makes sense to keep only the minimum in cash. Use your extra dollars to pay off any higher-rate debt.