Protect Your Money: Best Places for Cash

Editor’s note: As the market’s woes drag on into 2009, investors are looking for something—anything—to serve as an alternative to stocks. In this special report, SmartMoney examines three of those alternatives—bond funds, cash accounts and gold—to see where the opportunities and the pitfalls lie.

Before the market crashed, John Hayes never gave much thought to cash. A retired car salesman from Chicago, Hayes used to go online to see how his stock and bond funds were doing. But now he's scouring the Web for better rates and higher yields -- anything to eke out a decent return on his $350,000 cash stockpile.

It isn't easy. The yield on Hayes's money-market fund has dropped by more than a third, and the once-high rate on his savings account has fallen too. He could earn more on a certificate of deposit, but he'd rather not tie up his money. And he's certain inflation is lurking, ready to whittle away his purchasing power if he can't earn some interest. It's more than a little frustrating, he says: "I want to be conservative, but I'd still like to get something."

Preach it, brother. Investors are sitting on a record amount of cash, only to wonder what the heck to do with it. The credit crisis shook the bond market right along with stocks, leaving cash as the most reliable place to seek short-term shelter. There's nearly $4 trillion in money-market funds, and bank deposits grew 11 percent last year, to almost $8 trillion, as savers bailed out of other investments. And cash isn't losing its cachet anytime soon: In response to the market meltdown and recession, the savings rate is expected to grow to more than 5 percent in 2009, higher than it has been in 15 years.

But the financial crisis has also made the calculus of cash more complicated than ever. The Federal Reserve has cut rates and kept them low, making it harder for investors to earn a decent return. The average money-market fund now earns just 0.77 percent, or $770 a year on a $100,000 investment, and some savings accounts pay less than 0.5 percent. At the same time, the crisis has made some banks so desperate for deposits that they're paying more than 2.5 percent on some high-yield savings accounts. That could be a difference of $2,000 a year on a $100,000 account.

More challenging still, the options for cash have exploded. Between banks and money funds, investors have roughly 9,200 places to put short-term cash and access to all of them via the Internet. Brokers, meanwhile, are selling from separate lists of CDs, with their own terms and conditions. And no matter what you choose, there can be penalties, fees and disclosures that you'll miss without a magnifying glass. Even financial professionals find it confusing, says Bob Laura, a wealth manager at First National Bank in Howell, Mich., who's been buying CDs for clients recently. "You have to be extra careful."

Especially now. Forecasters predict the economy will get worse before it gets better, so investors may find themselves on the sidelines for a while. Another reason cash reigns today: With unemployment on the rise, having an emergency fund no longer feels like a luxury you can get around to eventually. So with an eye toward safety, returns and the fine print, we looked at three ways to keep your cash without losing your shirt.

With bailouts and financial scandals in the headlines daily, Richard Dukas started to worry that, with more than $1 million in one bank, he'd put too many eggs in one shaky basket. So one day last fall, during the 18-block walk from Manhattan's Port Authority Bus Terminal to his office, Dukas stopped at three banks, buying a $100,000 six-month certificate of deposit at each. No comparison-shopping for Dukas, who owns a public-relations firm in New York. "I just wanted it to be safe," he says.

CDs, also called time deposits, are essentially a contract with a bank. In exchange for a set rate, the customer agrees to leave money in the bank for a defined period. Every bank sets its own rates, and experts say it's fair to assume that the higher the rate, the more a bank needs your money-possibly because it's in trouble. Rates on 12-month CDs currently hover just under 3 percent, but Jason Sherman, a small-business owner in Oak Park, Ill., recently found a 4.35 percent interest from GMAC Financial, part-owned by beleaguered General Motors. (A GMAC spokesperson says the bank is well capitalized.)

Sherman figures that even if the bank were to go under, the Federal Deposit Insurance Corp. would cover his losses. Investors who bought what were called CDs from the now-infamous Stanford International Bank weren't so lucky. The government says the bank put the money into illiquid assets and that it didn't have FDIC insurance. An FDIC spokesperson says investors can check the FDIC Web site to see if their bank is insured. If it is, the government insures deposits and interest up to $250,000; the limit is scheduled to drop back to $100,000 after Dec. 31.

Buying from a broker, however, means learning a whole new playbook. Brokerages buy CDs from banks and sell them to investors; then the CDs trade like bonds. Hold them to maturity and they're like any other CD: You get your principal back, plus interest. But investors who need the money early are at the mercy of the market-a fact that brokers, who don't devote a lot of time to managing cash, aren't always diligent about explaining. Unlike banks, which spell out penalties for cashing in before the due date, brokerages typically sell your CD to someone else. If the interest rates are higher than when you bought it, you could lose money. That's why experts recommend buying CDs that come due in three-month increments; that way, an investor will always have some cash coming in.