The Difference Between “Liquid” and “Cash Equivalent”

Yes, Words Mean Something And Your Broker Will Screw You

I have long been warning investors about dealing with a full service broker; you know, the guy who cold calls when he’s new in the business and sits behind the big mahogany desk with a smirk if he eventually “makes it big”.

The enormous success enjoyed by online stock brokers, fueled by the internet revolution, has put many of these high commission, sometimes high pressure salesman out to pasture, but not all by any means.

The local stock broker is still popular especially among the elder, non-internet savvy, generation and even many younger unsuspecting people as well.

To a degree, this makes sense.

A retiree in his or her 70′s may not be best suited to buying common stocks online, although bonds are available too.

There are other investment products, often coupled with estate planning that may be more appropriate for these older folks, and the local broker may be seen as the obvious place to find them.

Even younger people may not turn to an online broker simply because they do not have the time or interest to become well enough informed to make their own investment decisions.

The Risk To Your Money If You Are Uninformed

The problem that will separate you from your money is if you don’t know how to talk to these full service brokers.

Here is an example:

One man in his 50′s, known for his hard work and business success but relatively unskilled when it comes to investments was given a call by his local broker when a bond matured and was redeemed in his account.

Now, being uncertain of the global economic situation, this man wanted to remain in cash. The broker, however, wanted to generate a commission.

All brokerages have a money fund (money market) of some type that strives to maintain a $1 share price – though NOT guaranteed to – and is without commission to buy or sell. But they can go by various names, often confusing to someone un-initiated with financial lingo.

So when the broker offered to put this mans money into a “tax free fund” that sounded OK to the investor, so he told the broker:

“I just want to stay liquid”.

The problem with that statement is that technically, any actively traded stock or bond is “liquid”, and so is a tax free bond fund; you can sell at any time and convert the investment back to cash (though your “cash” is subject to a day or more for the trade to “settle” before it becomes yours to withdraw).

The Difference Between Liquid and Cash Equivalent

The problem with that tax free fund that the broker put this mans money into was that it while it does pay a higher return or “interest rate” than a cash equivalent money fund:

• The tax free bond fund sports a 2% front load “commission”, so on a $10,000 purchase, $200 is commission that you will NOT get back if you sell the next day or even ever – unlike true cash equivalent
• The tax free bond fund does NOT attempt to maintain a stable $1 share price. When you go to sell in a week, a month, or a year, the price of the fund could be higher or lower – perhaps by a lot, so there is PRINCIPLE risk to your investment. Yes you could even generate a gain, but that is less likely than a loss – just trust me on that, especially with interest rates at record lows and bond prices at record highs.

What this investor wanted, but didn’t know how to differentiate in a way the broker couldn’t twist him around and generate a commission, was a CASH EQUIVALENT fund, tax free if possible.

He wanted to know that no matter what (barring financial Armageddon – which is possible these days) he would get back ALL OF HIS ORIGINAL money plus a small amount of interest.

With the “Liquid” but NOT CASH EQUIVALENT fund that the broker put him into, he will have to wait months or even longer to get back his original money. And that is PROVIDED that interest rates do not rise in the meantime which would cause the price of the bond fund to go DOWN.

(Yields on bonds move inversely to the price of  bonds.)

In fact, the only thing CERTAIN about this unsuspecting investor’s tax free fund is that the broker and his brokerage company made a $200 commission on his $10,000 of bond proceeds.

Now, if he decides he wants to buy another $10,000 bond he will have to wait until the value of that tax free fund grows 2.041% ($200 divided by $9800 – the amount actually invested in the fund after “load” or commission) and hope nothing else causes the share price of that fund to go down while he holds it.

But, the broker did increase the investors “yield” from .1% to 2% – but not without risk and a certain holding period that may be MUCH longer than the investor wanted. If this man decides in a month or two he wants to buy another bond, he will likely NOT have the full $10,000 he needs for the trade.

So don’t tell your broker you want to remain “liquid” when what you really mean is that you want to be in “cash”. A cash equivalent money fund is available in either taxable or tax-free variety, yields varying. The key is that there is no sales charge, load or commission to either buy or sell, and the share price is “targeted” (but not guaranteed) to remain stable at $1 per share.

A word to the wise.