Ho hum... What's the big deal?

Well, at least that's what you would be saying if you positioned yourself properly — by investing wisely, diversifying sufficiently... and using cash as your protective shield.

If you have not already joined the select group of cash-wise investors, now's the time.

The problem is, too many investors got burned more than they should have. They were spoiled by easy returns, lulled to sleep by overly optimistic stock indices and ill prepared for a rainy day.

Investors have been acting like children who forget that a hot stove will burn their hands. Well, entering the market without thought, without planning, with little direction, always burns you sooner or later.

Now, there's another potential problem on the horizon. Too many investors will never go near the stove again. They'd prefer to starve then to risk the pain.

But that's as unwise as it was to put all your money into a technology index fund six months ago.

The truth is, we all know that what goes down... must come up. The market will return, maybe not to the easy 20%-a-year gains of the long bull market (at least not every year).

But, as always, some investors in the coming days, weeks, months and years will find ways to make plenty of money, huge returns that will fund their kids' college tuition, their families' fancy homes, and their own retirement.

First, the fat and happy investor makes the smart investment choices, listens to his wisest advisers and follows the shrewdest advice. Second, the bear-proof investor takes the time not only to choose his investments carefully, but also to address all his financial issues, including expenses and liabilities.

Finally, the rich and successful investor properly uses one of the most overlooked tools in investing... cash.

A typical conversation with a broker on your investment portfolio might go something like this: "OK, you should keep about 10% of your assets in cash. The rest in stocks. Now as far as your stocks are concerned, you should buy a bunch of biotechs, diversify with international stocks, and if the market drops 80% stay with it, and my commissions aren't that much higher than other folks'"...

And on and on. But no more is said about what you do with your "cash."

Sure, you get lip service about how important it is to "diversify your assets." And you hear that you should put a certain amount in cash, a certain amount in fixed income, and a certain amount in equities.

And sometimes you even go so far as to sit down and actually decide what percentage to place in each category.

But, at this point in the process, too many investors execute their plan by... devoting practically all of their attention to stocks, a tiny bit to fixed income, and none at all to cash.

And that's a huge mistake. Because a little more focus on cash could boost your earnings — and even your stock profits — by a substantial amount.

How do you do this?

And right here, we'll make our first Clintonian qualification.

By "cash" we don't merely mean "cash."

After all, looked at narrowly, cash is just dollar bills, greenbacks, phony-looking twenty dollar bills that remind you of Monopoly money, and fancy new quarters with all sorts of state propaganda on the back.

What we really mean by cash is "cash equivalents."

That's a cool term, "cash equivalents." When you use it, it makes it sound like you know what you're talking about.

"Cash equivalent," as used here, is a financial product that passes the following two tests.

First, it must be relatively liquid. "Cash equivalents" refers to vehicles in which you can park cash, earn some interest, but still get your grubby little hands on that loot whenever you need to spend it. That is, when you need the dough to buy a custom-made suit, there must not be too much hassle in getting it.

They're like money garages, where you park your cash and can get it washed and waxed, but obtain your keys at any time.

Obviously, the most liquid of all cash equivalents is the cash you have stuffed under your mattress. But, for obvious reasons (it's not making any money, and anyone, including the tooth fairy, may make off with it) you shouldn't have too much there.

But not all cash equivalents need to be as liquid as water, or the Scotch you slug back when the Dow takes another 212 point hit. There might be minor obstacles, like early withdrawal fees. But, for our purposes, the product still qualifies as a cash equivalent if the obstacles disappear in a relatively short time.

Take certificates of deposit. You usually pay a penalty if you cash them in early. But as long as they mature before you need them, they're liquid enough.

If these products are short-term, they're sufficiently liquid for our purposes. "Short-term" is a relatively flexible concept. As long as you have enough cash available for your needs at any given time, you can afford to tie up your cash equivalents for, say, up to two years.

Second, a cash equivalent is relatively free from market risk. That is, the value of a cash equivalent doesn't drop just because some dot-com company changes its projected earnings from negative to extremely negative.

In other words, with a cash equivalent, you're not going to lose your principal. It will be there when you need it. It won't be subject to market forces or the fate of a particular corporation.

Of course, in another sense, pure cash can be quite insecure — that is, vulnerable to robbery.

Substantial income at little risk. And you can get your hands on the ready money when you need it.

That's a pretty solid combination.

Remember, this isn't in place of your stock investments. It's in addition to them.

Your cash equivalents are there to help you enjoy life to the fullest, and sleep well at night when the market's in the tank — as well as those times when your stocks are shooting up like an eagle on a caffeine high.

You see, proper use of cash equivalents can produce dependable and predictable income that can help offset any temporary losses in the market. Not only can that income be used to spend on things today, it can also give you enough confidence to make bolder stock market decisions.

Also, cash can serve as your investment cavalry. The percentage of your assets that you keep in the market should be within a certain range. So when you're at the low point in that range and an excellent investment opportunity comes up, cash can run in and buy it up.

When we talk about cash equivalents, we're not talking about certain longer-term income producing assets, such as long-term Treasuries, other types of bonds, preferred stocks, dividend producing stocks, municipals, REITs, etc.

Now, don't misunderstand. All of these investments can play a crucial role in your portfolio.

But they're generally less liquid than cash, and somewhat more subject to the vagaries of the market. In effect, they serve as an intermediate category between stocks and cash equivalents.

Rest assured, in future issues we'll talk about how you can best profit from them, too.

For right now, though, let's focus on the "Magnificent Seven Cash Equivalents" listed here.

Let's look at them one by one.

Cold hard cash. The biggest problem with cold hard cash is that it's not making any money for you. Plus, it's vulnerable to pickpockets. So keep the minimum amount you will need to buy candy bars at the 7-Eleven and pay tolls on the highway. Otherwise, use your credit card. Speaking of which...

Retiring debt. Yes, it's kind of strange to treat this as a cash equivalent. But there's no better return than paying off a loan, particularly credit card debt. It's one of the best uses for your cash. Sure, you're ending up with less cash — for the moment. But you're ridding yourself of an 18% annual interest liability. 18%! Think about it.

Where else can you get a guaranteed immediate return of 18%? In fact, if you don't have the cash, then take out a bank loan. If you can get a home equity loan, you can lower your rate and make it tax deductible. This will reduce your present cash in hand, but help your future cash flow.

Checking accounts and savings accounts. Use these sparingly. They are quite liquid, and very safe. Bank accounts are insured by the FDIC up to US$100,000. But they pay such a miserly amount of interest that it's almost insulting.

There are two advantages to a checking account with common savings account. First, you have easy access to cash through ATM machines. Second, you can write small checks, a convenience that most of us wouldn't want to do without. And then there are debit cards, a good way to have all the benefits of a credit card without the risk of getting in over your head. Basically, a debit card is just a faster way of writing a check against your checking account. But if the money's not there, you can't spend it. (On the other hand, you don't get the month or so free loan that you get when you use a credit card.)

Money market funds. You certainly won't be alone when you park your money in a money market fund. There are currently about 1.801 trillion bucks invested in these things.

Your better money market funds are offered by mutual fund companies. Banks are now offering money market funds as well, but often produce lower yields because of higher overhead expenses.

Money market funds are useful for several reasons. First, they're very liquid. You can usually write checks against these funds, although there's often a minimum check size, usually around US$500. That's why you need a regular checking account for the little checks.

Second, they're as safe as just about anything. Sure, they're not FDIC insured. But if you stick with institutions that are well known and strong, you have nothing to worry about. The extra cautious among you may want to spread your money out over two or three funds.

Let's face it. If T. Rowe Price starts defaulting on its money market obligations, we're all in trouble.

Third, you can get awfully good rates relative to bank accounts. We're talking 5, 6, 7%, as opposed to 2 or 3%. On a US$50,000 account, that could be a difference of more than US$2,500.

We say "more than" because interest is compounded! So you make interest on interest. Each extra percentage point you receive means more than a one percent increase in your income.

In addition, money market funds are as ubiquitous as crab grass. Thus, you will very likely find one that gives you the convenience, yield, and safety you want.

Now... what are money market funds?

They are collections of short-term, safe debt instruments. The instruments may be issued by governments and/or corporations. They mature in less than one year.

The short-term nature of these instruments, as well as their reliability, provides a great deal of safety. No one ever lost any money in a money market fund. They're not FDIC insured like bank accounts, but they're practically as safe. The price of the fund is normally US$1 per share, and rarely if ever shows significant fluctuation.

The only thing that changes is the yield. And the yields far surpass run-of-the-mill bank and savings accounts.

What are the downsides? Well, for one thing, if the stock market goes way up, like some of the returns we've been seeing in recent years, you miss out — but only for the portion you've put in a money market fund. That's why you need to allocate the proper amount to cash.

Also, in contrast to long-term bonds, you're not locking in the interest rate. Say, for example, that money market funds hit 7%. Wow, that's great. And say there's a 10-year bond out there also offering 7%.

If you put it in the bond, you are virtually assured of that 7% for ten years. But if you need the money before then, you may lose some of your principal if you sell before maturity.

In your money market account you can grab that money without losing any principal at any time. But if interest rates fall, so will the rate you're getting on the fund. You may be enjoying 7% now, but in no time at all that yield might drop to 5%.

When you search for a money market fund (or two or three), focus on these factors:

• Yield. There is a difference between the money market deposit accounts offered by banks and money market funds.

• Safety. Choose an institution you know and trust. If you want absolute safety, choose a bank money market that's FDIC insured. But you probably sacrifice a little bit of yield in exchange for what is likely to be a negligible increase in safety. Money market funds have been around since 1972. And not one investor has lost a penny in any of those funds.

• Taxable vs. tax-exempt. Some money markets invest in tax-exempt government securities. If you're in a high tax bracket, this may be worth considering. Of course, don't consider a tax-exempt fund for a tax deferred retirement plan.

• Look at management fees. Expect to pay an average of 0.5% of assets. Generally speaking, the more you pay in fees, the smaller the amount you will get in yield.

• Convenience. Check on how easy it is to transfer funds from or to a bank account. Also evaluate the check-writing privileges.

  You may want to make it part of a fund family so you can transfer in and out of stock and bond funds at times of your choosing.

  Also, how easy is it to redeem? With larger institutions, you can usually redeem your money over the phone, have it deposited directly into a bank account, or get a check sent to you.

• Minimum initial investment. This normally ranges from US$500 to US$5,000. Some have no minimum. Some are aimed at institutions, and have huge minimums like US$50,000 or more.

• Taxable or tax-exempt. Obviously, all other things being equal, tax-exempt is better.

Certificates of deposit. These are instruments offered at banks that guarantee you a certain amount of interest for a specified period of time. The advantage is that they lock in the interest rate for that period. But they also lock your money up for that period, too.

U.S. Treasury bills. U.S. Treasuries are debt instruments issued by the U.S. government.

Bills are Treasuries of one year or less. For the portion of your portfolio devoted to cash equivalents, stick with bills. Notes, which is what Treasuries of longer than one year are called, should be part of your "income producing assets," that is, the intermediate part of your portfolio.

A Treasury bill is sold at a discount to face value. A US$100 bill with a term to maturity of one year, if sold for US$94, has a return of around 6%.

First, determine how much you should place in cash equivalents so that you are financially and emotionally secure and your immediate needs are met.

What percentage of assets do you want in cash?

You can answer this question by looking at necessary expenses for the next three to six months (in case you get canned, for instance).

What needs are coming up and when? This will not only tell you how much money you need to keep in cash equivalents, but also how liquid they should be.

How much cold hard cash are you going to need in the next three months? Six months? Two years? Look at upcoming expenses, such as your child's tuition, the down payment for a new house, a new car, or that Sony Play Station 2 your kid's been bugging you about.

You see, if you can meet those needs with your cash equivalents, you won't have to cash out of the stock market at exactly the wrong time. Which means you can afford to sit out the bad times, hold fast, and avoid the ulcers.

Don't get me wrong. If you're in a stock that's going nowhere but down, get out. But you don't want to be forced to sell a promising company that's been dragged down by the panicking mob at exactly the wrong time.

If you have enough "cash," you won't need to.

Second, decide which cash equivalents to buy.

In choosing cash equivalents, look at the following factors: when the cash becomes available (without penalty), the income you'll earn, and safety.

All of the cash equivalents we've discussed in this article are as safe as can be. Certainly, you shouldn't put your entire wealth into any one; but if you lose principal with any of these, we're all in trouble.

Here's a suggestion: Put most of the money you'll need in the next two to six months in a money market fund. These pay much higher interest rates than savings and checking accounts.

For cash you won't need for three months to two years, consider certificates of deposit and Treasury bills.

And third, at least four times a year, reevaluate your portfolio diversification. Your needs may have changed. You're a bit older. Your kids are closer to college age. So you may want to increase your cash equivalent portion.

On the other hand, if your kids are now out of college and you have greater stomach for long-term and speculative investing, then you may decide to keep less cash around.

Regardless, it's important to monitor your funds on a continual basis.

Plan to do this four times every year.

Yes, you should keep an eye on all your stock investments. But don't lose track of what your cash is doing, either!